My mentor discouraged me from short selling completely until I become a more skilled trader due to its inherent disadvantages. Profitable trading, after all, is the accumulation of small statistical edges that, over time, will produce sustained profits. Here are the disadvantages inherent one faces when short selling:
- Asymmetric Returns
- There is only a possibility of 100% returns, while the downside risk is theoretically unlimited. It is rare, but it is certainty not unheard of for stocks to increase over two-fold.
- Negative Edge
- The markets have historically had an upward bias. This upward bias is not limited to US or European markets only.
- Psychology/Career Risk
- It is easy to make money while others are losing it, but extremely difficult to lose money while everyone else is gaining, especially if you are a professional money manager.
- Recall Risk
- Possibility of the lender requesting the stock back from the borrower before he/she is prepared to close-out. One study suggests that this occurs to roughly 2% of loans.
- Rebate Rates
- These are the rates a borrower is paid for his cash collateral, which are determined by the supply/demand for borrowing a stock. Taken from Fabozzi’s Short Selling: “on less widely held securities or securities with large borrowing demand, rebate rates may be reduced, in which case, the securities are said to be “trading special” or just “special…… In rare cases, when a stock is in high demand, the rebate rate can be significantly negative…. Only well-placed investors (e.g., hedge funds) will be able to borrow specials and receive the reduced rebate. Generally, brokers will not borrow special shares on behalf of small investors..”
For further reading, read Fidelity’s “The hidden risks of short selling“