Short Positions (also known as 'Shorting' or 'Going Short')

A short position is an investment strategy where an investor bets on the decline in a security's price. It is the polar opposite of the more common long position, where you buy a stock hoping it will rise. When you “go short,” you are essentially selling a security that you don't actually own. How is this possible? You borrow the shares from your broker, sell them on the open market at the current price, and wait. The goal is to buy those same shares back later at a lower price. Your profit is the difference between the initial selling price and the lower repurchase price, minus any fees. While it sounds like a clever way to profit from a falling market, shorting is one of the riskiest maneuvers in the investment world. For proponents of value investing, it's a strategy that is typically viewed with extreme caution, as its risk profile runs contrary to the core tenets of capital preservation and long-term, patient ownership of great businesses.

Imagine you believe shares of “Wobbly Widgets Inc.” are massively overvalued at $100 per share and are destined to fall. To open a short position, you would follow these steps:

1. 1. Get the Right Tools: First, you need a special type of brokerage account called a margin account, which allows you to borrow money or securities.
2. 2. Borrow the Shares: You instruct your broker to borrow, let's say, 10 shares of Wobbly Widgets from their own inventory or from another client.
3. 3. Sell High: Your broker immediately sells these 10 borrowed shares on the market at $100 each, depositing $1,000 into your account. At this point, you have $1,000 cash but also an obligation to return 10 shares of Wobbly Widgets at some point in the future.
4. 4. Wait and Hope: You wait for your prediction to come true. A few weeks later, bad news hits Wobbly Widgets, and the stock price tumbles to $60 per share.
5. 5. Buy Low (to “Cover”): Now, you “cover your short” by buying 10 shares of Wobbly Widgets at the new, lower market price of $60. This costs you 10 x $60 = $600.
6. 6. Return and Profit: The 10 shares you just bought are automatically returned to your broker, closing your loan. You started with a $1,000 credit and spent $600 to close the position. Your gross profit is $400 ($1,000 - $600). From this, the broker will subtract interest on the borrowed shares (stock loan fees) and any commissions.

The mechanics might seem straightforward, but the risks are enormous and asymmetric. Legendary investors like Warren Buffett and Benjamin Graham have famously warned against shorting, and for good reason.

This is the number one reason shorting is so dangerous. When you buy a stock (a long position), the most you can possibly lose is your initial investment; if you buy a share for $100, it can't go lower than $0. Your loss is capped at $100. With a short position, your potential loss is theoretically infinite. If you short Wobbly Widgets at $100, but a competitor unexpectedly buys them out, the stock could rocket to $200, $300, or even higher. To cover your position, you would have to buy back the shares at that much higher price, leading to catastrophic losses far exceeding your initial “investment.” The risk/reward ratio is horribly skewed against you: your maximum gain is 100% (if the stock goes to zero), while your maximum loss is unlimited.

A short squeeze is a short seller's worst nightmare. This occurs when a heavily shorted stock starts to rise in price instead of fall. As the price climbs, short sellers get nervous and start receiving margin calls from their brokers, forcing them to buy shares to cover their positions and limit their losses. This rush of forced buying creates more demand for the stock, which pushes the price even higher, “squeezing” the remaining short sellers and creating a vicious, accelerating price spiral. The GameStop saga of 2021 is a famous modern example of a devastating short squeeze that wiped out several professional funds.

Unlike owning a stock, which is free to hold (and may even pay you dividends), maintaining a short position costs money. You are constantly paying interest on the shares you've borrowed. This means time is your enemy. Not only does your investment thesis have to be correct (the company is bad), but it has to be correct within a specific timeframe before the borrowing costs eat up any potential profits. A bad company can stay afloat and “irrationally” priced for years—longer than you can afford to pay the fees.

For the average investor, the answer is almost always no. However, in the world of professional finance, shorting does have specific applications.

• Hedging: Sophisticated investors may use short positions to hedge their portfolios. For instance, if you own a portfolio of strong bank stocks but are worried about a general economic downturn, you might short a basket of weaker, overvalued financial stocks. The idea is that if the sector falls, the gains on your short positions will offset some of the losses on your long positions. This is a complex strategy that requires significant expertise.
• Activist Short Selling: Some specialized investors, like Jim Chanos, built their careers on identifying and shorting companies that were fundamentally broken or even fraudulent (such as Enron). This requires deep, forensic-level fundamental analysis and is a high-stakes game played by very few.

Shorting is a tool for speculation, not investment. It's a bet against a company and, in a broader sense, against the market's long-term tendency to rise. The risk of unlimited loss, the unfavorable risk/reward profile, and the pressure of time decay make it a dangerous game. The value investing philosophy encourages you to spend your time and energy finding wonderful businesses to own for the long term. It's a far more reliable and less stressful path to building wealth than trying to predict and profit from a company's demise. Leave shorting to the full-time professionals with the tools, temperament, and capital to play in that treacherous arena.