Volatility works two ways: Think it’s silly to fear a huge upside move in this market? Then talk to Pandora P, +1.45% shorts who have suffered a 50% surge in the stock in only two months. We’ve seen plenty of snap-backs in stocks over the past year or two, including last September and early October, when the S&P 500 lost about 7.5% as it went from 2,010 to 1,860 in a few weeks, then gained it all back and then some by Halloween.
Unlimited downside: If you’re thinking of shorting because you’re afraid of the risks of buying and holding, consider that the maximum loss on a long position is 100% while a short position has no cap. As a practical example, if you borrow shares and sell short at $10 and the stock goes to $20, you buy them back at a 100% loss. But if you are forced to buy at $30, that’s a 200% loss, and at $40 it’s a 300% loss, and so forth.
But lest you start thinking the safest bet is a bet to the downside, investors should keep in mind the serious risks that come with short selling in general, and particularly in the current market environment.
Given the uncertainty in the stock market — about the Federal Reserve, about what’s next in Congress after the October departure of House Speaker John Boehner, about China’s slowing growth and about uncertainty for the upcoming third-quarter earnings season — it’s natural for investors to turn bearish and consider wagering on a drop in shares.
According to a Bloomberg report this week, a key group of the most-shorted stocks in the S&P 500 Index SPX, +1.82% is down 28% since June, and suffered a one-day slide of more than 5% on Monday, when the benchmark marked its worst performance in four years. (Short selling is a bet on a decline in stocks.)