Why Short Selling is Too Risky for Most Investors
Short selling allows investors to profit from a stock’s decline in price. When an investor shorts a stock, they borrow a stock for the express purpose of selling it, hoping that they will be able to buy it back at a lower price. An investor shorts a stock because they believe that the price of the stock will decline by a certain deadline. When the deadline arrives, the short seller purchases the stock at its (hopefully) lower price to return it to its seller.
This strategy is quite high risk and has the potential for unlimited losses. For example, if a short seller borrows a stock at $10 a share, only to have the stock shoot up to $1,000 per share, the investor still has to buy back the share in order to return it. In this scenario, the short seller loses $900.
Short selling made headlines thanks to the recent Gamestop debacle. Hedge funds have lost approximately $3 billion short-selling Gamestop (so far). Gamestop is by no means the first example of short-sellers losing massive amounts of money. Tesla short-sellers lost even more in 2020. Unfortunately, no matter how many billions short sellers lose, some brokers still feel the need to recommend this high-risk strategy.
The Tesla Short
In 2020, investors who shorted Tesla collectively lost close to $40 billion. One of those short-selling investors included seasoned investor Michael Burry. Burry famously shorted the U.S. housing market just before the 2007 financial crisis. His housing market short sale proved so lucrative that it inspired the 2010 book and 2015 film The Big Short.
In the twenty-teens, electric car company Tesla became a favorite for short-sellers. Demand for electric cars is uncertain, leading many to speculate that Tesla shares are overpriced. Plenty of social media accounts targeted Tesla, sharing pictures of lots full of unsold electric cars, underlining their belief that Tesla shares were overvalued. (According to Musk, the full lots were due to the company’s struggles with delivery logistics.)
Tesla joined the ranks of the S&P 500 in November of 2020. This helped to boost its stock price. Retail investors have also demonstrated a considerable enthusiasm for the stock, thanks to speculation that electric cars will increase in popularity, as well as Musk’s growing fandom.
Short sellers controlled 16% of Tesla shares at the outset of 2020. At the outset of 2021, short-sellers only owned 6%.
What Happens If an Average Investor Shorts a Stock?
Investors taking a short position should know that their investment is high-risk and speculative. If a financial advisor misrepresented this strategy, the investor may be able to recover damages by filing a claim with FINRA.
In 2021, a financial advisor with UBS recommended a risk short-selling strategy to his investors — four couples that all belonged to the same extended family. Collectively, they lost a total of $23 million. According to the UBS financial advisor’s BrokerCheck record, the investors alleged that the advisor recommended that they continue “to hold the positions in the face of mounting losses.” The allegations call this strategy “risky and unsuitable.”
Financial advisors at even the most well-known financial institutions have been penalized for recommending short positions. In 2020, a FINRA arbitration panel awarded over $700,000 to an investor after their Morgan Stanley advisor recommended that they short-sell Amazon stock.
FINRA requires that brokers only recommend investments that match their investors’ risk tolerance. Short selling presents more risk than most retail investors can tolerate. Short-sellers are typically financial institutions that can afford to take on a lot of risk — hence why the short-sellers in the Gamestop incident were mostly powerful hedge funds. Massive hedge funds can afford to lose a lot of money, while the average investor cannot.
