The Risks of Short Selling

Short-only hedge funds are funds that adopt an investment strategy which is the exact contrary of the one followed by traditional mutual funds, that go for a long-only strategy. Although short selling may theoretically be considered symmetrical to the purchase of a security, in reality short selling entails very specific risks:
  • The downside of a short sale position is potentially unlimited. When all goes wrong, the worst that happens to a share is that it drops to zero, whereas on the upside it can rise forever. Faced by this statement, short sellers argue that according to their experience there are many more shares tumbling to zero than skyrocketing to heaven! In any case, a risk asymmetry exists between a long and a short position.
  • The risk of a short squeeze, when a broker demands the immediate delivery of lent securities. The short sale agreement gives the broker the right to call in lent securities at any time. Lent securities can be called in for various reasons: to take part in the company shareholders’ meeting or for extraordinary equity events, such as mergers.
  • The risk of a dividend payout. If the share pays out a dividend, the dividend amount is charged to the short seller and is paid out to the broker who lent the securities. Changes to existing tax laws can be dangerous for short sellers. For example, in the United States on 28th May 2003, President George W. Bush passed the “Job and Growth Tax Relief Reconciliation Act”, introducing a change in share dividend taxation: whereas before dividends earned by single individuals were taxed at a maximum marginal rate of 38.6 %, once the Act was passed the maximum rate was brought down to 15 %, like long-term capital gains, thus acting as an incentive for companies to increase the distribution of dividends to shareholders.
  • The impossibility of setting up a short sale as a result of the up-tick rule. Hedge funds, just as any other market participant, must comply with the regulations enacted in 1938 by regulatory authorities (in this case the SEC, but SEC’s regulations apply only to stock listed on NYSE or NASDAQ), allowing short sales only if the latest price change of the security being shorted was an upward movement (SEC rule 3b-3). In practice, short sales are authorized only if there was an “up-tick” (an upward movement between two immediately following prices) in the share price. As a result, it is forbidden to short a stock while its price is falling. In 1994, the SEC approved an experimental regulation, called “bid-test”, to stop short sales on stock listed on the NASDAQ at prices equal to or lower than the bid quote when the price is lower than the previous bid quote. 
  • The liquidity shortage risk. Generally, managers set up short sales only on large cap companies, which have a greater liquidity and therefore their shares are more available to be borrowed from a broker, and where the short squeeze risk is smaller. Often it is not possible to short sell small and medium cap stock, because the market for borrowing the securities has become tight. Short selling should be allowed only on financial instruments that are considered liquid enough to close out the short position by repurchasing the financial instrument. In the case of very severe crises, the financial instruments concerned are generally suspended, which puts the parties involved in a short selling contract under a liquidity risk.
Short selling is more complicated than long-only. Borrowing a stock may be difficult, expensive, and the share can be called in at any time. A successful short position narrows more and more as the share price declines, while an unsuccessful position grows in size.

The emergence of large private equity funds is the most recent risk for the short selling activity. Private equity firms in 2004 raised $85 billion, a huge amount of money if we consider that they can use leverage in addition. Private equity funds can target underperforming small and mid cap companies and can offer a premium on the current market prices for the control of some companies. The activity of private equity funds can be an obstacle to short selling, making it trickier to short companies.

This review is from: Investment Strategies of Hedge Funds (The Wiley Finance Series)
If you want to have an overview of the top hedge fund strategies, this is a good book to read. It is an overview though. It does not go deep into each strategy, and at times, the explanations are superficial, or inaccurate, ex: when talking about merger arbitrage the author mentions the collapse of the tender offer for American Airlines in 1989.... but it was really the inability to finance a going private transaction for United Airlines at $180 plus per share that marked the end of the LBO driven bull market of the 80's.