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Why is Shorting Stocks so Difficult?

Summary:
Did you hear about Tesla? Yeah, it’s up a lot. A lot. A lot. Like, hundreds of percent a lot. Or, 400% from its recent lows. Now, that might not matter much except that that rally now makes Tesla an extraordinarily large business by market cap. At 160B market cap they’re now the 44th largest firm in the world. That’s roughly the same size as McDonalds and larger than Nike. It’s FOUR times the size of Ford and GM. TWO times as large as Ford and GM COMBINED. Whoa. Much of this growth seems to be related to an extraordinary short squeeze that has made a lot of very smart people look very bad. Now, I don’t pretend to know a damn thing about the future of this stock. Back in another life I was a pretty good stock picker who took advantage of a pretty unusual discrepancy in analyst reports,

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Did you hear about Tesla? Yeah, it’s up a lot. A lot. A lot. Like, hundreds of percent a lot. Or, 400% from its recent lows. Now, that might not matter much except that that rally now makes Tesla an extraordinarily large business by market cap. At 160B market cap they’re now the 44th largest firm in the world. That’s roughly the same size as McDonalds and larger than Nike. It’s FOUR times the size of Ford and GM. TWO times as large as Ford and GM COMBINED. Whoa. Much of this growth seems to be related to an extraordinary short squeeze that has made a lot of very smart people look very bad.

Now, I don’t pretend to know a damn thing about the future of this stock. Back in another life I was a pretty good stock picker who took advantage of a pretty unusual discrepancy in analyst reports, but I don’t pretend to be able to predict which companies will perform well in the future. And honestly, I think anyone who pretends to know that is exaggerating the powers of their crystal ball. And while picking the winners in the stock market is hard, there’s one thing that’s even harder – picking the losers. But why is shorting so hard? Well, I know a little something about getting short squeezed because that happened to me regularly in my previous life. Shorting just never worked well and I quickly learned why. So, here’s what I learned from my trading days and why shorting is so hard.

1) Your Timing Has to Be Impeccable

Shorting is different from being long in that your timing has to be virtually perfect. The sad reality of being long a stock is that if it falls 50% you have to make 100% to get back to break-even. But time is on your side in that the long-term is often good to longs because stocks tend to rise about 75% of the time over any long-term period because macroeconomic forces lift all boats in the long-term. But if you enter a short trade and the stock rises 100% you don’t get a second chance. You likely get a call from your broker telling you the game is over. So your timing has to be perfect because the longer you hold a stock the more likely it is that it moves against you because the stock market spends a lot more time going up on average, than it does going down.

2) The Fees Will Compound Your Short-Termism

Fees will kill you in the long-term when you’re long. But they’re an even bigger killer when you’re short because they’re magnified. A typical long might pay a commission to own a single stock. But when you’re shorting you’re likely borrowing to short. And you’re also responsible for paying the dividends on that stock. In many cases the annual borrowing costs plus dividends will be double digits. So you can’t afford to think long-term because the fees you’re paying to short the stock are chewing you up every minute of every day. This makes #1 even more important and magnifies the importance of good timing.

3) S&P 500 Companies Are Winners

To become a member of the S&P 500 you have to have a market cap of at least $8.2B. That’s an extremely large company. This means that by the time a firm is even eligible to be in the S&P 500 they are extremely successful. Interestingly, just 9 companies are deleted from the S&P 500, on average, per year due to fundamentally poor performance. So, not only do you have a limited window in which to pick the losers, but the losers don’t become obvious over the short-term.

Conclusion

I think there’s an allure to shorting because it is one of the clearcut ways to provide potential asymmetric returns in the markets. But finding those asymmetries via shorting are likely to be more difficult to find than we might think.

Cullen Roche
Former mail delivery boy turned multi-asset investment manager, author, Ironman & chicken farmer. Probably should have stayed with mail delivery....

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