Why Shorting Preferreds Is A Bad Idea

by: Norman Roberts

Summary

Shorting preferreds is playing a dangerous game.

Their lack of liquidity and usually generous dividend distributions serve to increase that danger.

And the increased possibility of a forced close-out of a short position serves to increase the already increased danger.

Recently, several of my followers brought up the possibility of shorting preferreds, asking for my opinion. Rather than a long-winded answer in the comments section, I decided an article would better serve the purpose and explain the reasons why I feel this is a bad idea.

Because I learned not to assume that my followers possess all the information necessary to completely understand every one of my articles, I usually approach each as if my followers know little about the subject I am writing about. Consequently, let's start with what shorting actually is, and to explain it, probably better than I can, I usually turn to my old favorite Investopedia for the definition.

Short selling is the sale of a security that is not owned by the seller, or that the seller has borrowed. Short selling is motivated by the belief that a security's price will decline, enabling it to be bought back at a lower price to make a profit. Short selling may be prompted by speculation, or by the desire to hedge the downside risk of a long position in the same security or a related one. Since the risk of loss on a short sale is theoretically infinite, short selling should only be used by experienced traders who are familiar with its risks.

Consider the following short-selling example.

A trader believes that stock SS which is trading at $50 will decline in price, and therefore borrows 100 shares and sells them. The trader is now "short" 100 shares of SS since he has sold something that he did not own in the first place. The short sale was only made possible by borrowing the shares, which the owner may demand back at some point.

A week later, SS reports dismal financial results for the quarter, and the stock falls to $45. The trader decides to close the short position, and buys 100 shares of SS at $45 on the open market to replace the borrowed shares. The trader's profit on the short sale - excluding commissions and interest on the margin account - is therefore $5

Now for one of the primary reasons why I believe shorting preferreds is a bad idea.

There is a constant risk that the short seller has to face. Apart from this risk of runaway losses, the short seller is also on the hook for dividends that may be paid by the shorted stock.

Fixed income dividends are a primary reason why I and other preferred investors invest in them. Furthermore, preferreds are thinly traded and lack liquidity, which makes them poor candidates for shorting.

The initial difficulty is being able to borrow available shares the trader wants to short sell. After accomplishing this our intrepid investor now hopes for the preferred share price to fall, which will enable him to buy those shares back at a discount and lock in his profits. However, before he can accomplish this he is responsible to cover any dividends that were distributed to the preferred shareholder. Remember, those shares you sold had been borrowed; consequently, you owe the owner of those shares any dividends that were distributed and were collected by the shareholder you sold those shares to. And if by chance you have to buy them back at a greater price, expect your loss to be compounded by those dividends you now owe.

Furthermore according to Investopedia:

In addition, for heavily shorted stocks there is a risk of a "buy in." This refers to the fact that a brokerage can close out a short position at any time if the stock is exceedingly hard to borrow and the stock's lenders are demanding it back.

This could be especially difficult with preferreds because of their normally limited liquidity, which means the potential for the forced closing of a short position might be significantly increased. But this is ideal for a short squeeze when the already limited number of shares in the float are reduced even further. And this could be accomplished with an incredibly small amount of money. Another reason shorting preferreds can be a very risky bet.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.