Shorting: Risks, Rewards and How to Do It Right
Most investors probably have no clue what shorting a stock means and those that understand the process likely aren’t going to try in it due to complexity and risk. For clients undaunted by the challenge of executing the strategy, the case of Bill Ackman can serve as a cautionary tale.
Ackman, a hedge fund tycoon, declared multi-level marketer Herbalife to be a fraud five years ago and made a , claiming that the stock would eventually be worth $0. Unfortunately for Ackman, shares of Herbalife have surged more than 56% since he made his investment, even though his criticisms of the company may prove to be correct. According to media reports, Ackman was still short Herbalife as of earlier this year despite incurring massive losses.
Shorting is perfectly legal and provides a useful counterbalance to the sometimes “irrational exuberance” of the stock market. Wall Street money managers and other smart investors do it all the time. The potential profits can be enormous. However, pros like Ackman have access to far more risk capital than typical individual investors, and can afford to take the risks of short selling.
Advisors need to remind clients that losses on a short could at least theoretically be limitless because investors are responsible for eventually purchasing shares they sell regardless of price. It also can be difficult to borrow shares of some companies. Shorts can find themselves squeezed when the market goes against them and must have the fortitude to stand up to the common investor who want shares to rise. Someone who freaks out over every up-and-down in a stock’s daily journey shouldn’t be shorting them.
There are more conservative ways for clients to make bets, such as using a covered call strategy where an investor collects a premium for giving someone the right to purchase a stock in their portfolio at a set price at a future date.
Advisors should also encourage investors to have a coherent thesis before taking a short position and to definitely resist being led astray by “hot” tips. Ackman outlined his case against Herbalife in a 342-page presentation, and look where it got him. At a minimum, investors need to know what percentage of a stock’s float is already held by short-sellers. That will help them determine whether the risk they plan to take will be worth it.