By Dan David, Co-Founder and VP of GeoInvesting
Shorting stocks is rarely easy. In keeping with our practice to not only bring investors quality research, but also educate them, I wanted to run down some of the top mistakes I have made in the past when shorting stocks. If you are considering short selling or are already short selling, perhaps knowing the mistakes I've made in the past will help you become a better investor.
Over the last seven years, our research-based, on-the-ground due diligence has led to over 10 U.S.-listed China-based stocks delisted or halted. In addition, we have exposed over 10 pump-and-dump stocks that have resulted in 90%+ gains for those who shorted them.
Shorting U.S.-listed China-based companies can be grueling, mostly due to the fact that the companies you are up against can make up or fabricate information to combat your allegations. Many times I have opened a short position and have been immediately greeted by the company announcing a buyback or issuing a dividend in hopes of driving the short position out of the company. This happened when I shorted China Green Agriculture (NYSE:CGA) in 2014, and management declared a special dividend. The issue is that some of these companies have stolen so much money from the capital markets through stock offerings that they have money to play with even when their companies are not generating real revenue.
Shorting Stocks Opens You Up To Infinite Losses
Shorting stocks is a far more inherently dangerous practice than going long companies, and there is more risk in being short. The most you can make when going short is 100%, but your loss can be infinite (Remember KaloBios (KBIO)?). Even if you are right, your short position can be forced to be closed. Furthermore, you can pay ridiculous amounts of interest, sometimes 100% per year, on the shares you have shorted. Apparently usury is not illegal in the stock market. As such, we wanted to lay out that risk here today. Here are some of the top mistakes I have made over the years short selling that hopefully you can avoid.
Leave Your Emotions For Your Romantic Life, They Will Kill Your Portfolio
This is a universal shorting rule, but must be said; take emotion out of it. It's also one of the hardest rules. If you know you are right, dig deep inside and realize that when fraudulent stocks rally, they will likely eventually come down. One of the sickest feelings I have had is when I cover a rallying stock out of fear, only to see shares come right back down.
Assuming That Insiders Will Not Lie Is Naive
Failing to pay attention to insider ownership, which includes funds that have "special" relationships with management, is a mistake I made early in my investing career. The bigger the ownership, the more the chance that management will try to pump its stock by issuing false press releases in response to a short report. This has taught me to keep some powder dry for the pump.
Know The Risks Of Being A Hero
Be careful shorting shares of a state-owned enterprise ("SOE"). Accusing an "SOE" of fraud is accusing the China government of fraud. From my experience, the SOEs I have run into are frauds or at least have some material accounting misrepresentations, but the government will crush you before it ever admits that fact.
Always have a second or third account to play the "PR pump."
Remember, a fraud can say anything since they have nothing to lose once they are exposed, so more often than not they will put out a PR pump to squeeze you and dump their shares. I learned the hard way that if you just cover and try to short again at the top, you will never find the borrow again. Go long in an alternate account to box your short.
Putting Too Much Faith In The System Will Cost You Money
Do not count on the exchanges to halt a security. In my view, as a matter of policy, both the NASDAQ and NYSE are hard pressed to halt. They have come to realize that the risk of a suit by the halted company is much greater than the risk of any individual investor - and lest we forget, the exchanges themselves are for-profit companies that are paid by companies they list. You also can't count on the SEC to halt a U.S.-listed China-based company. The SEC has no power or resource to investigate inside of China. 'Nuff said.
Not Covering Enough Shares Ahead Of A Halt
Trading halts have gone from a desired outcome for shorts to a nightmare for all. As I already touched on, brokers are now known to raise interest rates from the high teens to over one hundred percent during a halt on borrowed shares! This gives the halted company insiders the ability to collect on the majority of that interest from their broker on shares they lent out to be short, which acts as an incentive to insiders of halted companies to prolong a halt as long as possible. This new trading dynamic is causing chaos on both sides of the trade.
Remember that shorting stocks is a volatile enterprise, and even experts have to expect the unexpected in situations where they are short. So, if you plan on involving yourself with this kind of investing, I hope that these tips and tools help you out going forward.
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. I have no business relationship with any company whose stock is mentioned in this article.