I’m eating lunch right now, and writing this post primarily as a self-reminder (so I can read it to remind myself DAILY). If you’re not like me (possessing the short-selling “genetic defect”), or even if you’re like me, you should avoid short-selling single stocks. Here are some reasons (ignore what others say, written by academics/non-practicioners):
- Your risk of blowing up, and/or experiencing crippling marked to market losses is very high, if not guaranteed. Most people (rightfully) cannot handle such volatility. Some people go insane, as a result. Insanity and poverty = bad.
- There is no free lunch. Credit default swaps and puts have their own risks that mitigate the blow-up risk, but present a whole new set of risk factors.
- Even if you’re one of those “I have 100-10,000 shorts” to reduce/eliminate risk of blowing up – you run the risk that you will spend 25%-50% of your time/efforts on a position that is 10 bps… okay maybe even 100 bps large. That seems like a waste of time. Or at least, your ROI on time seems inefficient.
- It is very difficult, if not impossible (assume impossible) to compound your capital with shorts the way you can with longs. It’s definitely more painful to attempt to do so with the former. How many billionaire short-sellers do you know vs billionaire long-term investors?
- It’s more tax efficient to be a long-term investor. This applies to most market participants, big and small, most of the time. You eat after-tax returns.
- Even if you possess the uncanny ability to find zeroes – in practice difficult/impossible to borrow, or very expensive to do so. So your effective expected return is far worse.
- Time-adjusted return matters as much as absolute return. So even if you have the uncanny ability of finding “terminal shorts”, zeroes, etc… say it takes 7-10 years…
- Short-selling is difficult/impossible to scale. Your opportunity set from $1 mm in capital vs $10 mm, $100 mm, $1,000 mm, $10,000 mm, $100,000 mm…. your opportunity set shrinks (not necessarily in a smooth fashion, but still it’s important consideration).
- Even in the instances your profit-seeking result in public good – e.g. outing a fraud – Some government officials will hate you (even when you’re working in their interest and have done nothing wrong!). To be fair, some will love you too, but the former make it all but not worth fighting the good fight. These introduce actual costs (legal expenses – lawyers are expensive) and opportunity cost.
- If you’re public about your shorts, you will receive hate mail, even death threats. And those sending you hate mail / death threats… they won’t apologize when you’re proven right. (okay, rare instance 1/1,000 will apologize).
- In practice, the criminals win… they may get caught/sentenced/fined etc years later, but they will have manipulated the stock, squeezed you out (illegally), leaving you with losses, even though you’re “right”. Job was a (relatively) righteous man, yet he suffered. His suffering was not a result of any of his actions. Lesson: Life is complex. Good things happen to bad people, bad things happen to good people, good things happen to good people, bad things happen to bad people. There may be a method to the madness, but it doesn’t mean you or I have it all figured it.
Addendum I to the so-called “Magna Carta” of short-selling
- Buy-ins (even if illegal behavior, market manipulation cause them, no recourse)
- foreign equities present additional complications, beyond listed above.
Addendum II to the so-called “Magna Carta” of short-selling
- See the career paths of those who possess the “genetic defect” – very few of them can boast of stable career lives (granted, the turnover in hedge fund and financial services industry is already high). Often dissatisfied with compensation, etc.
- The only business model whereby one can achieve some semblance of stability AND non-linear upside economics (for the manager) = the Kynikos funds’ business model. The problem is how do you sell it to investors? Granted, there must be a market for that “inverse alpha blah blah blah” model, as evidenced by Kynikos’ current and peak AUM.
- The above do not necessarily apply to “shorting” fx/indices/commodities/bonds/etc – though a whole host of other factors do.
- There seems to be a mismatch in the skills and daily disciplines required in the (I) research vs the (II) trading of securities. On one hand, one needs to be an analyst/researcher on par – if not vastly superior – to a long-only guy who possesses a concentrated position. On the other hand, one requires the trading discipline on par with a global macro trader. Contrast this against a long-term, long-only investor, whose research and “trading” duration are more aligned. (the above applies to position sizing as well).
Addendum III – Buyouts, etc.
- Companies you would never expect to be serious acquisition candidates, not only become so, but get acquired! And then written off 80-100% by the acquirer within 12-24 months’ time! (Sometimes a bit later)
- Updated December 2015: See GMCR as additional example
- The rules of the game can, and have, changed midway – e.g. disclosure rules, outright bans, etc
- You’re at the mercy of your broker – in more ways than one.
Addendum IV – moral victories and/or pyrrhic victories, get used to them
Addendum V – the Joys of Short selling
- the Joys of Short selling – microcaps – applicable to retail traders
“Try it sometime .40 cents to $45 to halted at $23 to zero 90 days”
Don’t forget: at one time, it cost -200% negative rebate to borrow KBIO
2. the Joys of Short selling – Institutional version
See case of the Hanergy fraud
“Falcon Edge held Hanergy short despite 7x return – told investors company ‘outright fraud’ earlier this year”