10 Biggest Risks with Shorting Shares & Indices
Modern short selling and especially the more traditional shorting of shares may be a risky endeavour but it is also a potentially lucrative investment strategy. To many, the idea of investing in reverse may sound crazy but if done well, the returns are worth the effort.
Traditional shorting a position essentially involves borrowing assets from brokers and selling them paying back the brokers but at a lower price. Modern shorting with CFD’s gives more opportunities, since you can enter almost any major shares and indices by pressing “SELL”, without owning the asset in advance. When the stock markets are highly valued in some regions and the global growth are slowing at an unprecedented rate, there are many opportunities coming up. But what about the risks? There must be quite a few right? Here, we don’t sneak around and admit that short selling can be a risky business if you are not careful, invest or speculate too heavily or don’t use stop-loss or take-profit every time.
Although short-sellers are key market intermediaries and play an instrumental role in increasing the market liquidity and helping lower the costs of capital at country level, there are significant risks involved with this investment strategy. This is because it is an advanced investment strategy and calls for greater understanding. Therefore, before going into short selling, there are 10 big risks you need to know.
Short Position Risks Around Major Events
Just like a skydive at nigh, short selling shares can be an exciting and beautiful experience. But beware of any major headwinds in skydiving, such as storms when about to do it. Better be cautious then too brave in some situations when the sight is not optimal. Similar is true for short selling. Major Events may include policy trajectories and announcements that may have greater implications on the market. Good examples are credit policies or budget announcements. This events may seem lucrative to short sell but the truth of the matter is that they can easily work against you. Same is true when the central banks are about to speak.
These events may not work in your favour if you choose to short a position because the gravity working on a stock is always stronger but you can easily be caught by surprise by levitation if there is a strong underlying trend in the market. This is because the cost of the market shares can easily plummet then pull up sharply, which can leave a short seller stranded.
Corporate Action Risk
This is a very common type of risk that faces short-sellers that are trying to short sell stocks around major corporate announcements like demerges, restructuring or mergers and acquisitions.
The common denominator in all of these instances is the logic of the corporate action or the swap ratio and it is often the unknown variable. This means that when you are thinking of risking of going short basing your strategy on a certain assumption, you should always keep in mind that are numerous instances where things have gone wrong. In all likelihood, you will get stuck in that position and the result will be the market forcing you to cover this position and it will come at a huge loss.
Risks with Going Short without a Stop Loss
In most cases, the investors buying stocks are more than those selling. This may explain why some big industry players’ equity indices trend upwards for a long time. This only means that they make sure to set their stop loss so that they protect their risk in case they go wrong.
For instance, imagine you short sell a mid-cap stock and it touches the upper circuit? Many of these instances have occurred and they have gone to as long as 3-4 days in succession. This means that you won’t be in a position to cover your short position. Furthermore, the position without delivery then also goes into auction, hitting you with major losses.
Risks with Short Selling against a Corporations
Many corporations are run by very smart individuals. Predicting whether or not these individuals will fail may be very tough. They can easily turn around a seemingly terrible event or bad business before you even get the chance to short their stock. This is not something that should be underestimated. Therefore, if you bet against them and their value increases, your will incur huge losses when others are reaping significant profits.
Holding on too long on Investments
The longer you choose to hang on an investment and owing dividends, the smaller your profit margins are going to be. The best way for short sells to work is to always think that the prices will go down either significantly or immediately enough for it to cover the dividend payments that you have to make.
The Risk of not Meeting the Margin Calls
Anytime you borrow from a broker, you must make sure to maintain a certain percentage of equity in your account. Of course this amount varies from one broker to another. However, anytime you fall below this threshold, your broker will force you to add more money into your account. This means that you have to keep enough collateral in your investment account. This amount is meant to cover a portion of the potential losses. If you are not ready to sacrifice some funds for liquidity, then the broker will close out the open positions.
Risking Unlimited Losses
The much you can gain from a risk with short CFD positions is limited to the funds you receive from selling the CFD. At the same time, the losses you can incur are unlimited. However, even though unlimited loss is just in theory, you should understand that prices could easily double before you get the chance of repurchasing the CFDs.
Risk of Paying Interests on Losses
Before you get into short selling, it is imperative that you have a margin account. If you do a short sell and the value of the starts increasing, your broker will start moving your funds from your cash balance to cover your losses. If you don’t sufficient funds to cover your position, a margin balance will be created. The margin balance will the start accruing interests. You may not suffer a loss for your position but you will lose funds in terms of interest charges for losing money!
Trading Halts and Delisting
When a trading in a stock is halted or corporation is delisted from markets, you may not have the ability to recover you position because that stock is now non-existent. Even if the halt or delisting is lifted, the process may take days, months. If the corporation is engaged in a bankruptcy proceeding, the process will be longer. You will still have experienced huge losses.
The Risk of Demand for Return
It is in the business of short sellers to keep their positions alive for as long as possible to earn them huge profits from a downturn in the price of the security. However, there are some cases where a lending broker may choose to immediately demand the return of the borrowed securities from a short seller. This happens if and when it becomes very hard to borrow securities. The broker will choose to charge more to lend out those securities that are hard to borrow. Therefore, it is in their financial interest to terminate an arrangement that is slow in paying to replace it with a lucrative one. This means that if a short seller fails to find another lender, there will be no other option but to unwind his position at a loss.