I started stock trading with a dream to leave my desk job one day and earn money full time from the stock market. At first, I intended to buy stocks of a good company and hold them. When the price goes up, I will sell the shares at a profit.
Soon, I learned that we could also make money when stocks go down. It’s called short selling. In this case, we borrow shares from brokerage and sell them instantly. When the stocks go down, we buy back the share from the open market and return it to the broker, and pocket the difference of share prices as profit. Depending on demand, we have to pay interest on the borrowed money to the brokerage during that period.
When I learned it, I became greedy. Too greedy, some might say.
My focus completely shifted towards short selling. My analysis was, there are thousands of companies. But not all of them succeed. The failure rate of companies is more than the success rate. In the short term, I can make more money by shorting stocks. So, I started shorting various companies.
When we buy stocks, hold them, and the share prices go up, we can make an unlimited profit (theoretically). If the share price goes down, at most, we could lose all of our initial investment. For example, if we invested $10 in a company and the stock price goes up to $80, our profit would be $70. However, if the company goes bankrupt, we would lose our initial investment of $10.
On the contrary, profits on short selling are limited, but losses could be unlimited (theoretically). For example, I short a stock when the price is $10. If the company goes bankrupt, its stock price will fall to $0. Therefore, profit is a maximum of $10 per share.
However, if, due to unexpected reasons, the share prices rise to $80, and we close our position at this price, our loss would be $70 per share. Now, if the $10 all you had when you invested, this negative $70 per share is pretty bad. You have to pay back this $70 to your brokerage.
In the long position, you could maximally lose all your $10 investment. In the short position, the potential loss is unlimited.
When I started, I was still naive in a few areas, and I blew my trading account with one bad short sell. Which I’m going to tell you next.
So, is short selling bad? Is it unethical? Should it be illegal? In this article, we are going to explore all these questions.
In the US, everything is tied up to the stock market. Our whole economy is dependent on it. Our pension funds, retirement accounts, everything, you name it, all depends on the stock market. If the market goes down, a lot of people get hurt.
However, during a market downturn, when everyone suffers economically, short-sellers make profits. During a stock market crash, when everyone loses everything, short-sellers make a lot of money. It’s why they have a bad reputation.
Elon Musk hates short sellers. He wants short selling should be illegal.
Before going further, I want to make clear that I no longer short sell. Now, I only hold shares in good companies that have promising futures.
Short sellers are not bad. They uncovered various scams and predicted market crashes multiple times.
It was the short-sellers who said the 2008 housing market was going to crash, exposed Enron as fraud, found Wirecard is involved in fraudulent financial activities, discovered Nikola Motors misled investors with false claims, and warned us about the dot com bubble.
However, in every sector, we have bad actors. There are hedge funds that try to manipulate the market for their gain. And for these people, all short sellers get bad names.
Some short sellers would sell shares and go out to spread false news and rumors. Because of social media, spreading fake news is easy nowadays. Because of these types of short-sellers, shorting stocks gets a bad name.
We have to remember that not all hedge funds are working together. Basically, they are out there to get each other’s money.
However, all hedge fund managers look down on retail investors. They have a derogatory term for us. They call us “Dumb money” it’s because they believe they are smarter than retail investors. Because of this, retail investors don’t like hedge funds.
These companies sometimes band together to manipulate the market. For example, if they see that a company is heavily shorted, they could artificially create a short squeeze. In this scenario, they start buying stocks to raise prices. When share price increases, short-sellers start covering their position, increasing buying pressure and sending the stock price higher. It’s a cascading effect and known as a short squeeze.
Long before 2021, I was caught in a short squeeze and lost everything. But, at the time, I was shorting a failing business. After several months I squeezed out of my position, the company announced bankruptcy.
So, shorting could be bad if you don’t have enough money to hold onto your position during a short squeeze.
Big hedge funds don’t have to worry. If they lose money, another company will come to rescue them. The fund managers would not lose their jobs, nor his monthly salary gets reduced. If every big institution loses money, the government will step in to help them. The government would bail them out.
However, as we are retail investors, there’s no one to help us out if we lose money. Therefore, now I always suggest everyone, not to short stocks. Because, whether you believe it or not, the game is rigged towards big institutions that are too big to fail.
In short, shorting is bad if you are a retail investor.
Now the question is it illegal? Unfortunately, No. It’s not illegal. In fact, it plays a vital role in stock market equilibrium.
If there are no incentives to expose fraudulent companies, why would financial institutions invest millions of dollars in investigating companies? So, all short sellers are not bad.
You can make a lot of money selling short, but you will not be popular.
Short selling is not illegal, and it’s not unethical. Similar to investors, short sellers also take substantial financial risks when they short a stock. If this bet goes wrong, it could end up pretty badly for a hedge fund. It could be devastating for retail investors. If you want to short sell, do it wisely, and if I were you, I would refrain from it altogether.