By Lee Sherman
Short selling is an investment strategy that is based on the expectation that a stock will decline in value in the short term.
When you short a stock, you don’t own it. Instead of buying your shares outright (taking a long position), you borrow them from brokers and sell them to buyers at the market price. When the price drops, you then buy them back at the lower price and return the borrowed shares to the lender (along with interest or a fee). If the company that you hold a short position in goes bankrupt, you lose nothing because the shares become worthless and you don’t have to pay the lender back. If this sounds like a get rich quick scheme you’re right. It’s also highly speculative and should only be done with the help of your financial advisor.
Here’s why: while it’s easy to see how you, as an individual investor can make a quick profit, what happens if, instead of the price of the stock dropping as expected, it actually goes up (sometimes way up)? What’s worse is that the math is not in the investors favor. Potential losses can far exceed potential gains. Short selling is a way of trying to time the market, which money managers say is almost impossible and shouldn’t be part of a long-term investment strategy.
Betting against a stock rather than investing in stocks that you can reasonably expect to rise in value is not generally recommended. A better way is to heed the adage “buy low and sell high” and do the research to find stocks with a potential upside. With a bit of trading experience behind you, you’ll be in a better position to identify stocks or market sectors that are currently under priced and expected to rise in value.
Short selling is generally frowned upon because it brings instability to the stock market and can have negative implications for the economy at large. Because so much of trading is based on emotion, shorting stocks can cause market distortions whereby the actual value of a stock is not reflected in its price. While, to a certain extent, you could argue that this is often the case anyway, there’s no doubt that short selling makes it worse. A rational market in a capitalist economy is one that is based on the potential for growth not on an expectation of decline. And, while it may not be immediately obvious, investors literally have a vested interest in a rational market.
Done right, short selling does have potential but it’s even riskier than buying shares in the latest hot Internet startup; if you don’t understand the rules, you shouldn’t play the game. Professional money managers will tell you that it’s much better to maintain long positions in stocks that you truly believe in.
Lee Sherman is a contributing writer to MyPerfectFinancialAdvisor, the premier matchmaker between investors and advisors. Lee is an experienced journalist and editor with over 30 years of expertise with a significant history of writing in the personal finance and technology arenas.