Tuesday, May 5, 2009

Shorting Stocks: Big Challenge with Little Reward

Most investors who are stock pickers have had the feeling at one time or another that a particular stock would go down. The usual response to this is to sell any shares they have or not buy shares. Some are tempted to short the stock, but this is a difficult game.

Shorting a stock means to sell shares that you don’t own. You are essentially borrowing shares from someone else and selling them with the promise that you’ll buy the shares back later and return them to the original owner. This is done with the hope that the shares will drop in value between selling them and re-buying them so that you’ll make a profit.

Unfortunately for short sellers, stocks tend to go up. Suppose that the stock market tends to go up 10% each year. So, investors in low-cost stock index ETFs make 10% per year, on average, without doing anything. To beat the index as a short seller, you have to find a stock that will go down by about 10% or more.

If a short seller just throws darts at a stock listing, he can expect to lose about 10% each year, on average. If he is so clever that he is able to pick stocks that perform 20% worse than average (so that they drop by 10%), his reward is that his investment returns will roughly match those of the know-nothing index investor.

Short sellers are like runners in a downhill race who choose to run uphill from finish back to start. Taking on added challenges is sometimes admirable, but don’t expect to win any races.


  1. Stocks, on average, have trended higher over time - at least in the past.

    However, over the past decade, that has not been true. I'm not saying that shorting stocks is a great idea (there are better, safer option strategies for getting short), but perhaps it's a new world and the idea that house prices and stock price always trend higher - is over. Who knows?

  2. Mark: The biggest driver of stock price increases (above inflation) is innovation. As long as humanity continues to invent new things that reduce the need for work and make our lives better, stocks will go up, on average.

  3. Another solution is to use those single inverse ETF instead of shorting stocks or ETFs. The inverse ETFs are safer than shorting stocks in general. You can only loose what you put in.

  4. Henry: It's true that inverse ETFs solve the problem of unlimited losses, but they don't solve the problem that stocks tend to go up, and you have to be way above average at picking the right time to buy the inverse ETF just to keep up with those who buy an index and go to sleep for a few decades.

  5. I find the pain of passing over a stock that goes up painful enough. If I were to short a stock and see it go up in a similar way, I would feel twice as bad.

  6. You know what I think you CAN short and have a good chance of making money? Short sell a leveraged ETF and hold it during volatile markets. It wouldn't matter too much if you chose the bull or bear version either. :)

    It's not as far fetched as you might think...

  7. Preet: That's interesting. I'll have to think about that one. The lost returns in both the bull and bear leveraged ETFs due to volatility make shorting them a possibility.

  8. You say that in order to have the same return as a market ETF or index, you would have to pick a stock that goes down by the same amount over the whole year. That involves keeping your short position open for the medium/long term.
    First of all, shorting is much more risky as there is unlimited downside. Obviously as you have stated, stocks trend upwards over time. That means that on average you would lose money every year, as on average the market goes up every year (apart from crashes & recessions of course).
    To make money by shorting stocks, you have to take advantage of the downturns that occur in a much smaller time frame.
    My point is that you should short stock on a day-trading basis (possibly swing trading) to take advantage of the small downturns that occur every odd day.
    That way, you just need to short a stock on the days it goes down (provided you can identify them :)...) and you can beat the 10%/year return any time...This involves quite a bit of knowledge, experience, and balls... I wouldn't recommend it..
    Anyway sorry for the lengthy comment, I just thought this had to be clarified.

    - rogue_trader

  9. Anonymous: No need to apologize -- I appreciate thoughtful comments, whether long or short. You are right that most short sellers look to make money over short time frames. Curiously, this doesn't change the argument very much. If we take as a starting point that most short sellers have no skill at choosing when to short a stock or index, the expected return over a total of a year's worth of positions is equal to the negative of the expected return on a year-long long position. Of course, the added costs of trading commissions and spreads will be significant if the trader makes many trades, and the day-to-day volatility will swamp the average market movement. Over time, though, the steady upward march of the stock market will work against the talentless short seller as his good and bad luck balance out.