Why shorting is extremely dangerous to retail investors?

I have previously written a few financial management or trading methods that are not worth trying for retail investors. This article “Investment concept not worth trying at all“. Shorting is the most obvious and least worthwhile stock trading method. This article will further explore why shorting is extremely dangerous for retail investors.

Table of Contents

Retailers are on a whim

First of all, most retail investors will go short stocks, the main reason is only one “stock price is too high and unreasonable, shorting is safe, because sooner or later it will fall” this way of operation based on irrational self-feeling only. Of course, this is not the case for all people. There are also some professional investment institutions that will sell short based on the unreasonable fundamentals of stocks based on very professional analysis. But our article focuses on general retail investors.

Agaist long-term trend of the stock market

As far as stock markets around the world are concerned, the long-term stock market trend is stable and upward, and those who are against the trend will not end well. I know that many people will immediately refute that Japan and Taiwan are not necessarily established. Only the United States was established. For example, Japan did not come close to returning to the high point of the bubble period until this year. However, I mean “long-term”, it may not be seen in your investment career, but it does not mean that it is not true (don’t underestimate the power of inflation, after decades of inflation, the index is no longer an unattainable number);.

We are not referring to the “myopia” vision of ordinary people, because for the stock market, ten or twenty years is actually a very short period of time compared to the entire stock market operation period. Just like before this year, few people would optimistically agree that the Japanese stock market can regain most of the ground lost decades ago. Before 2019, no one dared to expect Taiwan stocks to return to the 12,682 points in 1990.

The bursting of the Japanese stock market bubble occurred on December 29, 1989, and the Nikkei Stock Average reached a peak of 38957.44 points. On February 16, 2021, the Japanese Nikkei Index closed above 30,000 for the first time since 1990. The highest point in the history of Taiwan stocks was 18034.19 points in intraday trading, which occurred on July 15, 2021. The close was 18034.19 points, appearing on July 15, 2021.

Profit ratio is totally uneconomical

The possible profit of long stocks is “infinite”, and the worst may be the loss of all the principal you invested, which is 100%. But shorting is the opposite of longing stocks. The best possible profit is only 100%, that is, if the company goes bankrupt, you don’t need to cover it; but the worst possible loss is infinite. One side is 100%, the other side is infinite, which one is bigger, the answer is very clear.

In addition, since shorting is selling stocks that do not belong to you, you must pay interest to borrow the securities you want to short-sell from the broker. For example, the cost of borrowing a stock from a broker is about 6% per year (if it is a popular stock, the interest you pay will be much higher than this average number). If you make money later, this may not seem like much, but assuming that the stock rises by 14% after you go short, you will pay 20% every year to get the privilege of risky trading.

Retail investors are at an absolute disadvantage

Shorting requires a high degree of operating skills, which is not suitable for most investors. For example, investors must always pay attention to the shorting ratio of the stock and react quickly. Any disturbance will immediately change the market’s view of the stock, leading to valuation and market reversal. These are the reasons why retail investors and ordinary investors cannot react at any time.

Another point is that institutional investors have the natural advantages of overwhelming retail investors financially. Retail investors and ordinary investors cannot have strong financial support behind institutional investments. Institutional investors will often be accompanied by a large number of long buys when they are shorting.

By doing so to avoid risks and reduce losses when loss on shorting. However, this type of standard shorting operation for institutional investors when performing shorting does not have such qualifications for retail investors (for example, it is impossible for retail investors to do long buy at the same time to avoid risks); this is also the root cause of the inequality of retail investors’ weapons.

The risk of short squeeze

Professional short sellers generally believe that a net short ratio higher than 30% to 40% is relatively dangerous. Tesla (ticker: TSLA) had a long-term stock net short ratio higher than 30 before 2019. % Is a recognized high-risk stock (as shown below).

2011 to 2019, Tesla shares were shorted ratio, graphics from Bloomberg

A high short-selling ratio not only makes borrowing stocks very expensive, but also triggers the possibility of a frantic influx of large short-selling, because no one wants to be the last mouse. If the net short-selling ratio drops significantly, the possibility of short-selling will be greatly reduced. After a large number of stocks are covered, it will quickly push up the company’s stock price. If the company seizes the opportunity to issue a large number of new shares in a timely manner, it is possible to immediately improve the company’s short-term operations and greatly improve operating data.

Game Station (ticker: GME) and AMC (ticker: AMC) both use the market’s high attention to them to issue more stocks to raise cash, so that the company’s business can be transformed into a healthier status. To cite another more famous example, Tesla in 2017. Tesla also used the same financial method. In the end, the company survived and successfully reversed its life. For details, please see section 4-3 of my book “The Rules of Super Growth Stocks Investing”.

According to data provided by FactSet, for most of January 2021, the net short share of Game Station was higher than 100%. AMC Cinemas reached 57.81%. This is also what happened later – the share prices of Game Station and AMC fluctuated like a roller coaster.

Proved by historical record

In history, there has never been any investor who mainly relied on short-selling operations that can finally “retire with his whole body and become a huge wealth.” The most famous shorting operator in history is Jesse Lauriston Livermore, of course he made an enviable fortune, but his final fate was a tragy.

Author: Andy Lin

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