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Tesla Demonstrates Why Short Selling Is So Much More Dangerous Than Going Long

July 6, 2020 3:30 pm
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Tesla Demonstrates Why Short Selling Is So Much More Dangerous Than Going Long

Tesla Inc (NASDAQ:TSLA) shares ripped higher by another 10% on Monday as the Wall Street buying frenzy surrounding electric vehicle stocks continued. Earlier this month, Tesla reported its second-quarter vehicle deliveries were down about 5% from a year ago, yet Tesla’s market cap has exploded from around $40 billion a year ago to $245 billion today.

Tesla has the single largest short position of any U.S. stock, according to S3 Partners. And while short sellers pound the table on how detached the stock has come from reality, Tesla is a textbook example of how much more dangerous it is for traders to short a stock than go long.

Risk-Reward Balance And Fees

The primary reason short selling is more dangerous than buying is potential risk versus potential reward.

When an investor buys a stock, risk is capped at 100% of the investment. A stock price can’t go lower than $0, and rarely does it even come close. At the same time, potential upside is unlimited, and stocks often gain 150% or even 200% in a matter of a few years. Tesla shares are up 468% in the past 12 months.

When a trader shorts a stock, that risk-reward balance is reversed, creating a situation where potential gains are capped at 100% but potential losses are unlimited.

On top of that elevated risk level, short sellers must also deal with borrowing fees. For most liquid stocks like Tesla, these fees are relatively small, but they eat into any potential profits and add to any losses.

On top of borrow fees, short sellers are required by law to have margin accounts, meaning they're paying small fees on their margin as well.

If you're shorting a dividend-paying stock, you're on the hook for paying (not receiving) that dividend. Like fees, dividend payments can add up and eat into gains over time the longer a short position is maintained.

Short Squeezes And Buy-Ins

But one of the biggest risks of all in short selling a stock is buy-ins and short squeezes.

Short squeezes occur when a stock’s price rises enough to trigger short sellers to start closing out their positions. In order to close a short position, short sellers must buy back the shares they sold. Buying volume from long investors added to buying volume from short covering creates even more buying volume, triggering even more short covering and bullish momentum traders.

As a result, a stock price can rise exponentially in a short period of time, and some short sellers may have no choice but to take extremely heavy losses. Brokers implement safety measures called buy-ins to help protect investors from unreasonably large, out-of-control losses.

If on-paper losses get too severe, accounts can trigger margin calls, which require more cash to be added to the account.

If things get bad enough, the broker will simply close out short positions at market prices, which can often be the worst possible time to close a position. This short covering is known as a buy-in, and it's one of the most dangerous potential outcomes for short sellers.

Safer Alternatives

One potential alternative to short selling is buying put options, a strategy that caps losses at 100%. However, options themselves suffer from time value decay, which can also eat into potential gains.

Another alternative to short selling is to simply buy stocks that appear undervalued and stay away from stocks that are overvalued. As Tesla demonstrates, shorting a stock and getting it wrong or mistiming the trade can have serious financial consequences. But no trader ever lost a dime simply avoiding a stock that is overpriced.

Benzinga’s Take

Tesla now has a larger market cap than Toyota Motor Corp (NYSE:TM), making it the world’s largest auto stock by market cap. Unfortunately for Tesla short sellers, it doesn’t matter that Toyota produced roughly 30 times more vehicles last year or that Tesla has yet to have a profitable calendar year of operations.

The losses for Tesla short sellers continue to rise, and appeals to logic and market fundamentals are powerless during a buying frenzy and potential short squeeze.

Tesla shares are even up another 89% in roughly two months since CEO Elon Musk tweeted “Tesla stock is too high imo” back on May 1. Tesla's stock traded around $700 a share at that time; The stock trades around $1,337 a share at time of publication.

Do you agree with this take? Email feedback@benzinga.com with your thoughts.

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