Thoughts on NPR Planet Money's Short Selling Episode
Those who used to read my old blog know that I have no problem at all with short selling. See some of my old posts like 'The (Very) Basics of Short Selling', 'Short Selling *is* American' and 'Pick Your Spots When Selling Short'. So in that light,when I saw that NPR's Planet Money podcast did two episodes about short selling I was very interested in seeing how they'd handle the subject. The second of those episodes was the story of the first short sale ever, which was back in the days of The Dutch East India Company:
There have been short sellers throughout history. Today, the story of a man who was the very first short seller. The first person to bet that a stock will go down. It doesn't go well for him.
That was a very interesting story but I want to focus on the first of the recent episodes, which was titled "We're Short America". That episode was their version of 'Short Selling 101'. They explained how shorting worked and actually took a small sum of money and shorted the S&P 500. But they left out some things that I think are very important to fully explaining the risks of shorting.
Of course they discussed the fact that, in theory, you could lose an unlimited amount of money if you're short a stock that rises to infinity. But they neglected to mention that in practice things most likely won't play out that way. Here's why...
You can certainly lose a lot of money if a stock has a violent move against you. The most likely scenarios for that to happen are some news that hits while the market is closed which causes the stock to gap up when the market reopens. That news could be an acquisition or an FDA decision for a medical-related company, etc. In general, something that could gap 50% higher or more is most likely thinly-traded and/or a small biotech or pharmaceutical company.
So how do you avoid getting crushed by a huge gap against you? First, you could avoid shorting small-caps, biotechs or other types of stocks that are prone to those kind of gaps. You could (and should) also size your positions such that a huge move against you won't wipe out your entire account. (That applies if you're long or short!) So you can't eliminate your risk of ruin from a gap but you can lessen it by being careful about the types of stocks you choose to short.
Plant Money also failed to mention margin calls. In a more normal, non-huge-gap situation, when a stock moves higher over a longer period of time at some point your broker is going to hit you with a margin call. If you can't meet the call they will take you out of your position. That will happen long before your losses reach the theoretical infinity that's often used to scare people away from short selling.
Finally, you can use stop losses to protect yourself. (Again, they may not protect you from a gap opening though.) Many consider it a trading best practice to define a stop-loss point BEFORE you enter a trade 9long or short!). Ideally that stop loss point will get you out of the stock with a loss of less than 2% of your entire account value. So if you're shorting large(r) cap, liquid stocks, you should be able to contain your losses to tolerable amounts.
The 'Planet Money' story could have expanded on the requirements for short selling and how you can short sell. In the episode they only had about $400 to invest. One of the reporters mentioned that he had to add $2,000 of his own money to the account so that the account would be able to go short. (You also need a margin account, which, IIRC, is a point they didn't mention.)
The reporters decided that, for a few reasons, they didn't want to short a specific company. So they decided to short the entire market. Amazingly, they neglected to mention the plethora of inverse ETFs that exist for exactly the purpose of allowing investors to bet against a basket of stocks. Those ETFs can be a great way to short sell and you don't even need a margin account to do so.
In the story they shorted "this thing that tracks the S&P 500", which was probably the SPY ETF. Alternatively they could have bought the SH ETF to achieve the same effect. These ETFs are great tools available to individual investors and I hope that NPR will do a follow-up episode discussing the usefulness of all types of ETFs.