Do you short stocks? Many investors don’t; personally, I haven’t shorted since 2008, and here at Contra the Heard Investment Letter it isn’t part of our methodology. Yet since the start of 2021, short sellers have taken centre stage in a showdown between an army of retail investors and a handful of Wall Street hedge funds. A quick background — individual investors banded together online and strategized in a Reddit community called “wallstreetbets”. Recently the community began promoting a simple but clever strategy — buy heavily shorted stocks like GameStop en masse, thus forcing short-sellers to cover their position, and then watch the shares jump over the moon.

For those unfamiliar with short-selling, it’s an investment technique that involves “borrowing” a company’s stock, selling it, and then hoping the price goes down. This way you can buy the shares back later at a lower price, settle the loan, and pocket the difference. If the shares drop during the period you are shorting, you make money — but if the shares appreciate you lose money. In this article, we’ll look at all angles of shorting — the good, the bad, and the ugly.

Let’s get the ugly out of the way first. Shorting is probably bad for your health, wealth, and relationships. The math works against shorts from the outset. Succinctly, there’s no ceiling to how high a stock can rise, but there is a floor to how low it can go. Therefore, a short seller’s potential profit in a best-case scenario is dwarfed by how much they can lose if the stock surges.

In GameStop’s case, the ticker shot from $20 to over $450 in less than a month. If a hedge fund shorted a million shares at $20, they would typically need to put up about $6 million as collateral. By the time the stock hit the $450 mark, it would cost them $450 million to close the position, assuming they hadn’t used options like out of the money calls to limit the risk. Talk about ugly — especially considering the best that investment could have done was grow by $20 million (minus interest and any dividends paid). This is why shorting is sometimes compared to collecting pennies in front of a bulldozer — there’s a distinctly asymmetric risk-reward profile. (By contrast, the worst you can do by going long is lose your position — but the best you can do is unlock a Bezos or Buffett-style fortune).

In addition to having an ugly side, shorting has a bad reputation, because short sellers stand to profit from a company’s misfortune. Those who short (especially professionally) can often give off a predatory vibe, or one of questionable ethics. Many a short seller has been accused of exacerbating an economic crisis, forcing a company into bankruptcy, or pushing people out of their homes or jobs — because of this, they are easy to label as villains.

Warts and all though, short sellers have a function in the market ecosystem. Imagine for a moment a stock market without shorts — all bets in that market would be one-sided and long only (excluding options, of course). One-sided betting like this doesn’t make sense. For a market to function well there must be a way for contrary opinions to express themselves. Shorting, however unpalatable it may be, is an avenue for naysayers and adds to the intellectual diversity that characterizes a balanced market.

Being able to bet long and short also helps maintain some level of price rationality. A world where investors could only bet long would likely lead to extreme levels of overvaluation, while a world where investors could only short would similarly result in extreme undervaluation. Neither of these worlds sound sensible.

Perhaps most of all, short sellers are valuable because they can act as detectives and help to uncover financial fraud. For example, shorts played a key part in highlighting accounting scandals at Enron, Sino-Forest, and Valeant Pharmaceuticals (now Bausch Health Companies). Not only can they uncover malfeasance, but they can make lax regulators, cheerleading fund managers, and a bullish public take the accusations seriously. Yes, in many ways short sellers are predatory — but so are some corporations, and when that is the case, it’s best to fight fire with fire.

So there you have it — the good, the bad, and the ugly. Overall, shorting is a thankless job. They stand to lose a lot more money than they can make on any given trade. Some people hate them too, and yet they are critical to uncovering skulduggery. Considering the bigger picture, I suggest that the next time you see a short seller strolling down the street, take a minute to thank them for shouldering an asymmetric risk/reward profile, playing the stock market villain, and working to uncover financial fraud while also attempting to balance valuations. Like vultures, they have an unpleasant but ultimately important place in the financial market ecosystem.