The structural difficulties of short selling

The payoff profile of a short position differs fundamentally from that of a long position, and the practical difficulties of short selling follow from this difference.

Asymmetry of payoff

A long position has a maximum loss of 100% and an unlimited potential gain. A short position has a maximum gain of 100% and an unlimited potential loss. This reversal has direct consequences for position sizing and risk tolerance.

In addition, a losing short position increases in weight. A short position against which the price has moved by 50% represents a substantially larger share of the portfolio, at the point at which the manager would least wish to hold it. A losing long position diminishes in weight; a losing short position expands. Positions that expand when incorrect are a principal cause of fund failure.

Costs of carry

Borrow fee. The short seller pays a fee to borrow the shares. For hard-to-borrow securities, the fee may exceed 20% per annum, and the securities most attractive as short candidates are frequently the most expensive to borrow, since other participants have identified them as well.

Dividends. The short seller must pay to the lender any dividends paid on the borrowed shares.

Recall risk. The lender may recall the shares at any time, compelling the short seller to close the position, potentially at an unfavourable price. Recalls are a common trigger of short squeezes.

Time. A long position can be held while the thesis develops. A short position incurs borrow costs throughout the holding period, so that a thesis that is correct but premature may nonetheless produce a loss.

Categories of short thesis with favourable characteristics

Fraud and accounting manipulation. These offer the highest conviction but are the most difficult to substantiate. Indicators include persistent divergence between cash flow and earnings, related-party transactions, changes of auditor and restatements.

Structural decline. A business model being displaced by a superior alternative. The decline is typically gradual, and timing is the principal difficulty.

Financial distress. Excessive leverage, approaching maturities and no viable refinancing. Such situations carry a defined timeline, which most short theses lack.

Hedging positions. Short positions held to neutralise a factor or sector exposure rather than to profit from the individual security.

Categories of short thesis with unfavourable characteristics

Short positions based solely on high valuation. Overvalued securities may become more overvalued for extended periods, and no mechanism compels convergence to fair value within a timeframe the short seller can sustain.

A valuation-based short position without a catalyst or balance sheet constraint is, in effect, a position against market sentiment, financed by borrow costs and carrying unlimited downside. Experienced investors have incurred severe losses in such positions while being correct in their assessment of value.