There are perils to shorting stocks. Real Money Pro's Doug Kass does it well, but he's had years of experience. Years of bumps and bruises. Years of good times while others didn't enjoy the action around them. Years of survival. Survival -- that's the key. Capital preservation. Live to fight another day.
Getting caught on the wrong end of a short carries significantly greater risk than getting caught on the wrong side of a long position, assuming one stays off margin, of course. Kass is one of the veterans who understands this, but unfortunately, there are many out there who don't.
Take, for instance, the story floating around the web this morning of a trader who openly admits to being negative over one-hundred thousand dollars (-$100,000) in his trading account as a result of being short KaloBios Pharmaceuticals (KBIO) prior to the close yesterday.
Now, I don't know this trader personally and can't verify the story as being true, but based on the action of the stock, if one were short 9,000 or 10,000 shares, then it would be altogether possible. The basic thesis behind the trade was that KaloBios was winding down operations and trading above the perceived net liquidation value. Therefore, you short the stock assuming there is no upside catalyst, and for a short position of around $20,000, you could stand to make 10% or 20% with what you see as very little risk.
I get the thesis. There's logic there, but this trader misunderstood the risk and not because the stock went up -- because of something else. The trader, according to the story that I'm paraphrasing, put $37,000 into an E*Trade (ETFC) account, because he believed he could lose $37,000 and still be alright. That's where the misunderstanding comes in. Shorting carries unlimited risk. I'll say it again: shorting carries unlimited risk.
The trader wrongly assumed his account would be stopped when it reached zero dollars, but neglected to account for after-hours and pre-market action creating gaps in a stock. Furthermore, the market can move so fast that when the account hits zero, it can go very negative before a market order is even executing, assuming your trading platform enters the order on your behalf.
I remembering hearing Jim Cramer speak about the dangers of shorting stocks in the single-digits. While there is money to be made, there is a different mentality with single-digit stocks, in my view. All it takes is a small rumor and you can pump a stock such as Arch Coal (ACI) from $2 to $10 in a matter of days or push up SunEdison (SUNE) 20% in a few minutes.
Often we see these rumors or news fade away and the stocks wind up where they started the run, if not lower, but many traders can't stomach the loss on paper or find themselves forced to cover because of a short squeeze. A few traders make their money just shorting these crazy moves in penny stocks, but trading in that manner fills more graveyards than pockets.
In the end, this story feels sensationalized to me. Whether fact or fiction (and I truly hope it is the latter), there is a lesson to be learned. No matter what your account size, if you are outright shorting stock (or shorting calls), your loss potential is not limited by the size of your account. Say it with me: shorting carries unlimited risk.