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5 Reasons Not to Short Sell Stocks

Many novice investors have often asked the question "what does it mean to be long vs. short?". When most outside of the investing world think of investing in stocks, they think of the "long" side. Here the objective is to find stocks of companies that are appear to be priced too cheaply relative to earnings or net assets. The stock is then held until the price appreciates to a value at or above a fair price against these metrics, at which point it should be sold. This "buy low, sell high" philosophy is what investors mean when they talk about being long.

However, it is possible to take the other side of this phrase and "sell high, buy low" - although it should really be labeled "borrow high, buy low" as we will see. This type of position is known as "shorting" a stock. In this article, I will examine the mechanics of shorting a stock, why investors do it, and finally, why I believe that investors following the Magic Formula Investing (MFI) strategy should avoid any "black magic" formula to short stocks that rank poorly.

How Shorting Works

Shorting involves borrowing shares of stock from a current shareholder, selling them at the current market price, and then buying them back for the original borrower at a future point in time. The objective is to sell the borrowed shares at a price higher than the price you buy them back for, pocketing the difference from the price decline. Here is a simple example of a successful short of a recent MFI stock:

Borrow 1,000 shares of Jackson-Hewitt (JTX) on 9/2/2009 at $4.85 a share. Immediately sell them for gain of $4,850, which is usually held in escrow by the broker until the trade is completed.

On 3/19/2010, JTX trades at $2.40, and the short-seller decides to cover, buying back the original 1,000 shares at a cost of $2,400. The escrowed funds are released, and the net profit from the short is $2,450.

On the other hand, here is an example of an unsuccessful short sale:

Borrow 1,000 shares of Questcor Pharmaceuticals (QCOR) on 9/2/2009 at $5.99 a share, which are sold for a total of $5,990.

The short-seller watches as QCOR declines to $3.50 in November, but decides there is more downside to the stock as it sells an un-patented drug (Acthar) at a ridiculously high price, and faces new competition to boot. However, QCOR receives new regulatory approvals and insurance companies continue to reimburse the cost of Acthar. QCOR rises to $7.57 on 3/19/2010, at which point the short-seller decides to limit his losses, buying back the 1,000 shares at a total cost of $7,570. His net on the short is negative $1,580.

Why Investors Short

Obviously, the primary reason for selling a stock short is to profit from difficulties that particular companies face that are expected to lead to price declines in the stock. This could include a deterioration in the industry, technological changes that render products or services moot, an overburdening debt load, and so forth. Shorter-term factors like insider selling or reduced earnings estimates can also be an impetus for short trades.

Shorts are sometimes used to hedge the risk in an existing long position. An example of this would be owning a natural gas stock for a time, then seeing nat gas prices begin to decline. You could hedge your position by shorting the commodity, which means some of the downside in your stock position could be offset by gains in the short.

5 Reasons I Don't Recommend "Supplementing" MFI With a Short Strategy

Several readers have mentioned the possibility of adding a short-side strategy to MFI in order to profit from companies that do not profile well mechanically. A couple examples of this would be to short the stocks that rank at the bottom of the MFI methodology, or by using such mechanical screens as Piotroski to find the lowest ranked stocks to short.

These are valid strategies. Shorting is a perfectly viable way to make money in the market. It's also risky. Here are 5 reasons I don't recommend the practice for MFI investors, who already have a simple and market beating long-only strategy on their side.

1) Limited Gain, Unlimited Loss Potential

Unlike long positions, where losses are limited to the initial investment and gains are unlimited in scope, a short position has just the opposite. You can only profit 100% if the stock goes bankrupt. On the other hand, if you do not use a stop-loss order, the potential losses are unlimited if the price goes ever higher. This can be exacerbated by...

2) The Short Squeeze

A "short squeeze" is when unexpected good business results lead to buyers flooding in and the stock price quickly rising. Investors who had sold the stock short may rush to cover their positions at once, in order to limit potential losses. This virtuous circle can drive the share price sharply higher in a short amount of time, exceeding stop-loss order limits before they can be triggered.

3) Swimming Against the Tide

Over the history of the stock market, the overriding trend has been that prices go higher, to the tune of about 6% a year (before dividends). Management teams, equity holders, and creditors all have a vested interest in the positive outcomes of a business. There are a lot of forces working against your negative bet on the stock.

4) Dividend and Tax Penalties

Since an investor that shorts a stock effectively has a negative number of shares, any dividends the company pays on its shares must be paid by the borrower (short-seller) to the equity holder (who the shares were borrowed from). So, in effect, dividends dilute the gains (or lengthen the losses) from a short position. Also, any gains netted on a short are taxed at higher income tax rates, regardless of how long the position was held. This is opposed to much lower capital gains tax rates for long positions held over a year and a day.

5) Difficulty and Advanced Nature

Finally, and perhaps most importantly, shorting is an advanced strategy that should really only be used by experienced investors who pay close attention to the market. Magic Formula Investing (MFI) was designed to be simple to implement and not consume a lot of time, while still outperforming the market at large. Setting up short positions and then not paying close attention to them is a recipe for trouble.

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