The Risk of Shorting Stocks

I know there are risks to trading. Talk about an understatement. The funny thing is, no one really considers the risks when they decide to take the market on.

Probably human nature. Focus on the positive. Only consider the benefits if done right of trading for a living. No commute, no trading time for money, no useless meetings. Just your own schedule, you and your screens and trading platform, and money rolling in month after month.

Well, don’t forget there are risks. I wanted to focus primarily on the risk of shorting stocks.

No one really talks about shorting stocks, unless they are already a short-biased trader. You won’t hear it in a positive light on CNBC.

Occasionally they’ll say it’s necessary, it makes a market, yadda yadda. But the reality is everyone wants (and usually thinks) stocks only go up, or should only go up.

Because a rising stock market is a positive thing (a slight tone of sarcasm).

So what is a short-biased trader to do but assume things have gone too far and should reverse, only to find themselves short, then adding, shorting some more, then add some more until they get squeezed?

No discipline, no risk management. Just the conviction bias that they are right and the market is wrong.

Well, what happens is you end up losing money as the stock goes up, and when you add to your position up to all the cash in your account, you lose all your cash. Unless your broker is able to cover your position. Which they usually try to do to protect their interests considering if you go negative then you owe them money.

What is worse is shorting easy-to-borrow stocks and using large amounts of margin as well. This couldn’t be further from the craziest thing you could do especially on a stock that is strong, in a strong market.

And yet it is done by short traders large and small, day after day, week after week.

The risks of shorting stocks are all about not knowing how far the stock can go. It can go further than you think and stay up there longer than you believe is possible, or rational.

You are better off just buying a few shares of these rising stocks if you need to place a trade so badly that you throw out every strategy, and rule, and disrespect your capital. Scratch that itch and buy 10, 20, or 100 shares and just set a stop loss and you might be surprised.

Don’t let the conviction bias monster get you.

Yes, even in this bull market I am still finding opportunities to short stocks, but I follow a very specific set of strategies for all of my trades. I trade a very strict set of trading setups that I teach. Following these setups has worked well over the years, so I simply decided to narrow my focus and stick with what works.

Shorting stocks has its risk, but if you know where to find the right key support and resistance levels and you have this information at your fingertips with solid risk management and discipline process in place, you can capitalize when stocks reverse and minimize that risk as close to zero as anyone can get.