Learn to invest

Is short selling stocks for beginner investors?

Barstool Sports’ Dave Portnoy famously said “Stocks only go up.” And he was right, until they didn’t.

Scores of individual investors — especially ones which have started during the pandemic — are starting to see that the stock market is a fickle, cyclical thing. The market fell more than a third at the start of the COVID-19 pandemic, rallied to all-time highs in the months that followed, and is now down more than -20% from those same highs.

That has gotten investors thinking: could I profit if stocks go down? The short answer is yes, but the long answer is not to worry about it.

That’s because, although stocks do go down, there are massive risks that investors encumber when they decide to bet against the market. To Portnoy’s point, there is some truth to stocks only going up – Considering one of the most popular asset classes, in the U.S., equities have risen for nearly the entire history of the country. Betting against this seemingly inevitable thing could be quite silly.

But say there’s a stock or ETF you really do expect to crash directly into the ground. What would you do then? Well, many investors would say that they would “short it”, because the American investor zeitgeist is filled with famous short sales which paid off. However, there’s really any number of ways you could bet against it. 

In truth, there’s a lot of reasons why short selling isn’t an optimal strategy — not just for individual retail investors, but also for firms. Because to our former point, stocks largely do go up… and short selling means betting against the market. 

Since 1957, the start of the “modern S&P 500” index, the index has returned an average annualized return of 10.67%. Since the turn of the century, the index has only posted seven down years (and is on track for its eighth if the index holds where it has been for most of 2022.)

That means that the index definitely has bad years, but continues to win on the whole. That comes with many risks. So what do you need to do? 

Is short selling stocks for beginners?

If you’re not too familiar with short selling, we’d encourage you to check out our previous blog post on the subject that more thoroughly explains the deeper details of the matter. 

In a nutshell, shorting stocks refers to borrowing a stock or ETF and then selling it. You’ll pay interest to borrow the stock, sell it, and then wait for the stock to drop. Once you do sell it, you can pocket the income from that sale — but you’ll be sitting on an obligation to return that short sold share to its owner.

Let’s examine a similarly risky strategy and see how it stacks up against shorting.

If you know a thing or two about the options market, consider this: about 30-35% of options contracts expire worthless. In other words, betting against stocks using a “safer” method, results in complete loss in about a third of scenarios.

Compare this with short selling, in which short sellers reportedly lost $91B in January last year. Of course, this particular year was likely a rougher year for the shorties as a whole because of the meme stock movement that carried into 2021, but an over 50% loss rate is still really treacherous, especially for beginners. 

To address the question though, short selling is not recommended for beginner investors as the losses are theoretically unlimited. When you buy a stock, there’s conceptually no limit to how high the price of the stock can go. But, as you’re betting against the stock, the more it goes up, the more you lose, which makes this strategy particularly risky for beginner investors. 

Short selling isn’t even available to most investors who use popular trading apps like Robinhood and others, and this is because of the level of financial fortitude and overall mastery it’s assumed an investor would need before taking on this strategy. 

Okay, but why is that?

What makes short selling often more risky than any other investing strategy is the potential to lose more than what you invest. When you’re bullish on a stock and you buy it, the risk is of losing the total value of the stock if this goes to zero, so the loss is capped. 

This is not the case for short sellers, as they open themselves up to unlimited loss. GameStop and AMC, anyone?

A good (scary) example

GameStop short selling

Because of the fact that the potential for loss on shorted equities is essentially limitless, this can create a nightmarish, worst-case scenario event if all the conditions come together in the right way, and at the right time. 

Take the 2021 GameStop rally for example. Investors identified that GameStop stock was heavily shorted, prompting a buying rally meant to “squeeze” the hedge funds short on the stock into eventually losing millions of dollars. 

Hedge fund investors, whose job is to try to beat average investment returns for clients, can also    get burned shorting stocks, which speaks volumes of caution in the direction of beginners. 

A sobering takeaway

You should not only identify a solid opportunity with the right equity but also try to accurately forecast the future price action of a stock, which may require a ton of due diligence, or in rather few cases some lucky guessing. 

Anyone willing enough to put in the hours and dedication could become a good short seller. But that same time and diligence could be invested in more proven strategies for beginner investors like Dollar-Cost Averaging or index investing. 

Track your Stocks & Crypto in one place

Download Front