You still keep the original $500 so your total loss would be $2,000 minus commissions and any dividends you had to pay me along the way. (The fact that you have to replace any dividends I would have been owed is one of the reasons short sellers aren’t particularly font on shorting high dividend yield stocks. Combined with the fact that high dividend yields attract buyers interested in passive income and you understand why the concept of yield support is such an important one for certain types of firms.) On the other hand, if the company goes bankrupt, the stock will be delisted and you can buy it back for next to nothing – a few pennies per share, most likely – pocketing almost all of the earlier sales proceeds as profit.
The Dangers of Shorting Stock Should Not Be Underestimated
When you short a stock, you are exposing yourself to a lot of potential financial pain. In some cases, when investors and traders see that a stock has a large short interest (a big percentage of its float has been shorted by speculators), they will attempt to drive up the price to force the shorts to “cover”, or buy back the shares before it gets too out of hand.
It is important to remember a few things if you are thinking about shorting stock. First, never assume you will be able to repurchase a stock you have shorted whenever you want at a price that resembles ordinary experience. The liquidity has to be there. If there are no sellers in the market, or there are so many buyers (including panic buying, which is caused by other short sellers attempting to close out their position as they lose more and more money), you have a serious problem. The most famous, and catastrophic, example of this is the Northern Pacific Corner of 1901. Shares of a particular railroad went from $170 to $1,000 in a single day, bankrupting some of the wealthiest men in the United States as they tried to get their hands on shares to buy them back and return them to the lenders from whom they had borrowed the stock.
Next, never assume that for a stock to go from price $A to price $C, it has to go through price $B. You may or may not have the opportunity to buy or sell on the way up or down, prices may instantaneously reset, the bid or ask jumping. It is something that is obvious to experience investors but new investors take for granted. Even in regular stock investments that do not involve shorting stock, there is this mistaken idea that a stop loss order can protect you under all circumstances, which simply isn’t true. The major risk as it pertains to shorting stock is a corporate buyout or merger. It isn’t unusual to wake up to an announcement that a company is going to be acquired for 40% higher than its stock price including a special $10 per share dividend or something, which means the short seller is instantly harmed in a major way.
Finally, shorting stock is subject to its own set of rules. For example, you cannot short a penny stock, and before you can begin shorting a stock, the last trade must be an uptick or zero-plus tick.
If You Insist Upon Shorting Stock, Consider Buying an Out-of-the-Money Call Option As Partial Insurance Against Catastrophe
If you are going to short stock, think about limiting your potential losses by purchasing an out-of-the-money call option. Sure, it will cost you money and potentially cut into any gains you would have made but it might be the difference between a painful, buy survivable, disaster and a catastrophe that destroys your family’s finances for years.
Let’s look at an example. Right now, on March 19th, 2016, any fundamental investor or quantitative analyst can tell you the shares of Netflix are disgustingly, offensively overvalued. They trade at a price-to-earnings ratio of more than 361. While it is true that a high p/e ratio does not always mean a stock is overvalued, in this case, it does. Even Netflix’s management has expressed astonishment that investors are so foolish to pay a price this detached from reality.
The stock price is $101.12 per share. Imagine if you wanted to short it. To keep it simple, we’ll say you want to short 100 shares and we’ll ignore the small commissions you would otherwise owe. You borrow the stock, sell the shares, and pocket $10,112. At the same time, you decide to buy 1 call option covering 100 shares with a $200 strike price dated September 16th, 2016. The contract costs you $0.28 per share, or $28 total, plus a small commission.
Now, you are sitting there with $10,084 in cash in your account ($10,112 proceeds from selling borrowed stock minus the $28 you paid for the out-of-the-money call contract) plus a -100 shares of Netflix showing on your account register. If Netflix declines, you want to buy it back for less than $10,084 with the difference, adjusted for the commissions along the way, amounting to your profit. However, if something crazy happens – say Netflix suddenly jumps to $500 a share – you would have an offset. Yes, you’d need to buy back 100 shares at $500 each for $50,000. Yes, you would have lost almost $40,000 shorting the stock. However, your call option would be worth a fortune. You’d be able to exercise it, force someone to sell you 100 shares of Netflix for $200 per share (taking $20,000 out of your pocket) then use those shares to replace the borrowed shares you sold earlier.
Put another way, before commissions, you’d have turned what would have been an almost $40,000 loss into a loss of a little less than $10,000. That’s a roughly $30,000 savings. True, you still lost money shorting stock but as far as insurance policies go, it was a cheap one.
Buying a Put Option Is Often a More Intelligent Way To Gamble Than Shorting Stock
In many situations, buying a put option, which gives you the right, but not obligation, to sell stock at a predetermined price is the more intelligent way to gamble on a company’s shares collapsing. That type of trade involves its own unique risks but it can be far more compelling than shorting stock under the right circumstances because you can limit your total losses whereas your losses are theoretically unlimited when you short stock.