With Seeking Alpha's increasing popularity, we see quite a few new contributors and users signing up each day, most of them admitting to being new investors/traders. This article is aimed at such newcomers. After reading some of the comments on "short ideas" articles, we thought an article presenting the dangers of shorting could be a welcome addition.
When you see the experts making money by swing trading and by shorting stocks, it's normal for the beginners to think they can also play the shorting game. This article presents a few reasons why one should be wary of shoring stocks, be it even the worst company on the planet.
Momentum Plays: How many fans of valuations have been wondering about Salesforce.com's (NYSE:CRM) 4 digit PE? Right now, the company is losing money and does not even carry a PE. How can this stock stay so high? Well, the answer is institutional support. No matter what has happened over the past few quarters in terms of results or valuations, CRM has been propped up by the big brothers. What chance does a small investor have on the short side when the big funds do not let the stock go below an extent? You can surely find a lot of frustrated CRM shorts right here on Seeking Alpha. The point is, when dealing with these speculative plays, valuations do not matter in the short term. In the long term, yes one might turn out to be right about the valuation but how many people have the nerves of steel and the liquidity to overcome the storm?
Slingshot: Even Apple (NASDAQ:AAPL), which is not really a speculative play, has violent up and down moves. While CRM seems to be a case of the big funds not letting the stock go down, Apple is a more curious case. The institutions just love to bring it down so they can ride it all the way back up for much more gains. It might not just be AAPL. There could be many more such companies that are beaten down just to make the ride up more fruitful. When the average investor joins the party late in shorting these fundamentally sound companies, it will not be long before the rug is pulled from underneath and the funds choose to go on the long side.
Takeover/Mergers: Research In Motion (RIMM) comes to mind in this category. Every other day, Microsoft (NASDAQ:MSFT) or some other big company is rumored to buy out RIMM and there is a short squeeze for a day or two before things return to normalcy. And of course there are mergers which eventually go through. Beaten down companies like RIMM, Nokia (NYSE:NOK) or even Eastman Kodak (EKDKQ.PK) could spring back violently on real mergers or rumors.
Bad Management: There are quite a few people who short a stock because they do not like the company's management. While there are quite a few leaders/CEOs the investors love, there is at least an equal number of CEOs that investors cannot wait to see go. Microsoft's Steve Ballmer comes to mind. With so much negativity around him, one has to wonder what kind of positive impact his retirement/stepping down news will have on the stock and how a "shorter" will be impacted due to this unexpected hypothetical happening.
Hint of Positive News: Amazon.com (NASDAQ:AMZN) is a clear example here. The valuations have been obscene for quite some time. The stock was heavily shorted ahead of its recent earnings report in April. It closed trading on April 26th at about $193 and after releasing a "not so great, not too bad" results, the stock shot up and closed the next day up about 15% at $226. The expected EPS was continuously revised to the down side and even then it required a "one of gain" to beat the estimates. The point is, if the analysts decide to "cook a beat," they will. End of story. So, even a neutral or "not as worse as we thought it would be" result would create a short squeeze and hurt the small "shorter".
Time Is Not Your Friend: When going "long" on a stock, you know time is on your side. Of course, the stock you buy could go down to zero. But at least, you got a floor there. Where is the ceiling on any stock price when you short ? There is none. You must rely on your timing than relying on time when you short a stock. Not too sure how many are good at it, especially the beginners.
Conclusion: So there you have 6 of the many reasons why shorting should not be part of a beginner's plans. We request readers add their own reasons below so we have a meaningful discussion.
Disclosure: I am long AAPL.