For many investors, experienced and novice alike, the idea of short selling stocks can be enticing. You can make money investing even if the stock market is in a downturn. You can earn a profit on days when others are losing money.
But selling a stock short can severely punish investors — especially if they don’t understand the risks.
What Is Short Selling?
You can win on a bet — no matter which way the stock is moving — as long as you’re guessing the right direction. Short selling allows you to invest in stocks even when you think that their share price will decrease.
Unlike typical long investors, who buy hoping that share prices will increase, being on the short side of the position, or a short seller,
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is the exact opposite. You’re actually counting on the shares decreasing in value. Naturally, that’s a little counterintuitive for many investors.
When you think that a stock’s price will decline, you can tell your brokerage firm to short the stock for you. Essentially, you’re borrowing shares from the brokerage and then selling them; when — or rather, if — the price declines, you purchase the shares yourself at a lower price, return those “borrowed shares” to the brokerage, and lock in your profit. The brokerage earns a commission on the transaction and a small amount of interest in most cases, depending on how long you borrow the stock.
The Downside of Short Selling Is Infinite
One reason short selling is risky for investors is that the amount of money you can lose on an investment is essentially unlimited. There’s technically no cap to the downside you can experience when an investment you’re shorting turns against you.
For example, if you’re a traditional long investor who thinks a stock’s price is going higher and you’re wrong, the most that you can lose is the total amount that you invested. If a stock you bought plummets to zero, you lose your entire investment. Of course, few of us would let it get that far before we sold in a panic.
It’s different for an investor who’s selling a stock short, betting that the share price will decline. If you’re wrong and the stock price rises, there’s technically no limit to how high it can rocket to. And as a short seller, you will be, at some pointrequired to buy those shares you borrowed from your broker, at whatever price, so that you can return them. So there’s a potential to lose a substantial amount of money if the stock price increases rapidly.
Short Selling May Not Be Liquid
You might also find it hard to find a company and its market maker willing to offer shares on loan for you to short. Many investors go to their brokerage to do this — but your brokerage firm has to own the shares for you to borrow.
An interesting side point: Many investors don’t realize this, but in nearly all cases, the shares of stock you buy through brokerages aren’t technically held in your name — they’re held by the firm “in street name.” (The reason? It massively simplifies the paperwork involved in buying and selling stocks, but never fear. In practice, you still own the assets you think you do.)
When a brokerage holds shares in street name, it can then turn around and lend them out to its other clients to sell them short. Of course, they’re still your shares, and you can redeem them anytime.
Given that, you might not be able to sell shares of a company short if they’re not liquid enough. Small and medium-size companies simply have fewer shares available for brokerages to lend to their clients. If a brokerage firm doesn’t have a client who owns the shares you want to short, and it can’t get them in the market, then you won’t be able to short them.
Short selling can be a lucrative investment option. It has a lot of allure because it lets you play the other side. But short selling can be very dangerous for the new or inexperienced investor. Investors should not take selling shares short lightly.
Have you ever bought shares of stock short? How did it work out for you?
Note: This article originally appeared on AOL Daily Finance and is reprinted with permission.