Why short selling is risky

I often write about companies I dislike and companies that I have sold short. I have made a good return on my short sales. Yet I have always recommended against short selling. Why I recommend against short selling was amply demonstrated by the stock of microcap Noble Roman’s (OTC BB: NROM) yesterday. The stock shot up 46% on no news. What happened? My bet is that the critical article on Noble Roman’s that I posted on Monday encouraged some people to short the stock and it encouraged some momentum longs to sell. That drove the price down 30% over the next two days. Yesterday some short sellers started to cover and that drove the stock price up a bit. Momentum players jumped back in long and soon the stock was back up to where it was Monday. Of course, this is just my idle speculation, but the effect on the stock price is quite real, no matter how it happened.

If someone shorted the stock at its low yesterday, that person would now be out a lot of money. They might even blame me for their losses. Yet for any stock, the short term is not indicative of the long term. In the short term the stock market is a voting game. Especially for small, illiquid stocks, prices fluctuate greatly depending upon supply and demand. But in the long term, the stock market is a weighing mechanism, and poor companies’ stocks will inevitably flounder. Most people have a hard time holding on to stocks they have bought (long) despite swings in short term prices. It is even harder to hold on when, with short selling, losses can theoretically be infinite. So stay away from short selling.

Disclosure: I am still short NROM and have not traded it since my first article on it last Monday, as per my disclosure policy.

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