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Short Stocks: Should investors bet against stocks?

shorting a stock

In the world of investing, there are endless ways to profit and just as many ways to lose. 

This is one reason why investors traditionally choose to buy and hold. Investors that “go long” on ETFs, blue-chips, or defensive stocks are traditionally rewarded over the time horizon they choose to invest often many years, or even decades.

However, what about shorting a stock? After all, the payoff could be pretty great if markets contract like they did in 2020 (because of the COVID-19 pandemic) and 2022 (because of the changing macroeconomic environment.) 

Unfortunately, while shorting stocks sounds great in practice, it carries with it greater risk than your traditional “buy and hold” strategy. In fact, betting against stocks, ETFs, bonds, or commodities can be downright hazardous for investors who are misinformed, unsure of what they’re doing, or aren’t careful. 

Oftentimes, investors find themselves at the intersection of those three states; saddled with double-digit losses. Even people who consider themselves studied in the markets can find themselves with considerable losses. 

But old habits die hard — and new market participants often think they are different; that they can somehow evade being made of an example of by the market’s unpredictable and chaotic nature. With the resurgence of interest in betting against stocks, namely because of the GameStop short squeeze and the market’s correction in 2022, scores of new investors are asking, “wait, should I bet against stocks too?” 

It might not be the best thing for your portfolio, but if you’re interested in shorting stocks, bonds, or other assets, we’ve composed a shortlist of strategies at your disposal to do so. We’ve also ranked them from risky to downright dangerous.

Inverse / Bear ETFs

Many investors choose to buy and hold major indexes such as the S&P 500, Nasdaq-100, and Dow Jones. Some might even choose to get more granular and invest in sector-specific funds which track technology, healthcare, or biotech. When these funds rise, investors make money.

For that reason, it only makes sense that there’s somebody offering investors a bearish alternative: to bet against them. Inverse ETFs, which are sometimes referred to as Bear ETFs, offer investors a way to make money when these popular indexed products, commodities, and bonds actually lose value.

These inverse ETFs, however, come with many risks of their own. You are not only betting against assets which have a track record of appreciating over the long term, but are often designed to only match the inverse daily performance of its alternative product. For that reason, your long-term returns might not be indicative of the opposite leg of the trade.

And as if that isn’t risky enough, many inverse and bear ETFs come with a leveraged flavor. In other words, you can bet to multiply your gains when assets drop (or lose even more boatloads of money if they keep climbing.)

Related: Why should you diversify when investing in ETFs?

Utilizing Options Strategies

If you have ever pushed money around in the stock market, you likely have some familiarity with retail investors’ favorite derivative market: the options market.

The options market is like a casino for pricing. You can make bets on assets going up, down, staying between a set price, staying above or below a certain price during a certain period of time, or any other number of perplexing combinations involving time, money, and the unpredictable.

There are a slew of options strategies that investors tend to utilize when betting that a stock, ETF, or other financial asset will drop. If you have any interest in trading options, you should become studied in all of these strategies before making trades 

Options are tricky, though: unlike with inverse ETFs, moves perceived as likely in an asset will likely be priced into the premiums or cost of buying an option. In other words, if there is a lot of time left on an option, or if the likelihood of something happening is considered to be likely, then this will likely be priced in. 

This can make option trading significantly more difficult and dangerous than buying ETFs or stocks, no less because you can be saddled with complete loss of capital.

Shorting Stocks, ETFs, or Bonds

If you’re looking for the most direct path to profiting from an asset’s downfall, then shorting it might be your best bet. 

Unlike buying a bear ETF or acquiring an appropriately-flavored option, taking a short position requires two things: borrowing a stock or ETF and then selling it. 

That might sound deeply perplexing to the layperson. After all, you can’t “borrow” a house or a car that doesn’t belong to you and sell it. But this is the stock market… we didn’t say that things had to make sense. 

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 say you sold 100 shares of a stock for $10. That’ll be $1,000 sitting in your trading account. However, you’ll be paying interest on the borrowed shares you sold. You’ll have to eventually buy the stock back (ideally at a lower price) and return them to its original owner.

Assuming everything goes your way, you’ll be able to buy the stock back for cheaper. Say, maybe $5. That means you’ll profit $500, less the interest you paid to borrow the stock.

However, things might not go your way. In that case, you’ll have to buy the stock back at a premium. Say, maybe $15. You’re now out $500 and owe interest for borrowing the stock you shorted.

In the worst case scenario, you might have to return the stock to an owner earlier than you had hoped. However, the biggest takeaway to have from shorting is that you could be at “infinite risk” of losses. If an asset’s price continues to rise, or if the cost of borrowing the asset increases because of demand for shorting it, you might be saddled with considerable losses. In some cases, you can lose multiple times your principal.

The risk, unpredictability, and knowledge required makes shorting a risky strategy, even for the most seasoned investors.

Related: What is Factor Investing? Factor Investing for Beginners.

Is there an ideal way to shorting a stock?

We won’t tell you what to do, but be cautious when considering strategies which run 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. So, if you decide to use one or more of these strategies above in your portfolio, consider paper trading them before putting money on the line. Familiarize yourself with the finer points of allocation, portfolio management, and tax optimization.

You could start to build on your knowledge using the front app. Connect your crypto wallets and brokerage accounts to start tracking all assets in one place and see the bigger picture. 

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