In the topsy-turvy world of the stock market, the idea of investing in reverse might sound fitting, or it might sound crazy. Short selling is a risky, but potentially lucrative investing transaction that’s a backward version of buying and holding stocks.
When selling short, you borrow an asset from a broker and immediately sell it. Your goal is to see the price drop and then return the shares and pay the broker back at a lower price. Short selling is fundamentally different from “going long” a security in every possible way. Here’s how:
1. You’re betting against an asset.
If you go long with a security, you purchase it hoping that it will increase in price and you can sell the stock back. When you short sell an asset, you are hoping that the asset will decline in value. The more it drops in value from the time you initially borrowed and sold the asset, the higher your profit.
2. You receive cash up front and then pay at the end.
Again, this is exactly the opposite of what you’d normally do. Since you’re starting the sale at what you hope is the stock’s peak price and then paying for the shares when you return them, your goal is to return the shares at the lowest price possible.
3. If you hold onto the security, you are required to pay dividends or interest.
Stockholders often receive dividends or other incentives for owning shares. But when you’re selling short, the asset really belongs to someone else. The firm or individual who lent you the shares still deserves to collect, so until you close your position by purchasing and returning the shares, you are responsible for paying dividends.
Should You Sell Short?
Short selling is hard for many investors to understand, because it seems so irrational to invest in reverse. But it can be a great strategy when you’re sure that a security will decrease in value. For example, if a recent investment news story claims that a major weather pattern is likely to threaten major corn patterns around the world, you might believe that selling short can make you a nice profit if corn prices dropped significantly.
Short selling is an advanced strategy, so you need to consider these six major issues.
1. Unlike going long with an asset, you can incur unlimited losses.
The biggest risk in short selling is the potential for infinite loss. When you go long an asset, you know you can lose 100% of your investment if the stock price drops to $0. As bad as that loss is, at least your potential loss stops at your initial investment. Short sale losses, on the other hand, are limitless. For example, imagine you started a short sale at $20 and the shares increase in value by 500% to $100. You’d have to buy the shares back and return them at $100, essentially losing 500% of your capital!
2. Be careful when you bet against a company.
Corporations are run by smart people, and it’s tough to predict whether or not they’re going to fail. Never underestimate their abilities to turn a bad business or terrible event around before you short sell their stock. If you short sell an investment and it increases in value, you will lose money while everyone else enjoys the profit they made while going long.
3. Dividends can eat up your profits.
The longer you hold on to an investment and owe dividends, the lower your profits are going to be. Short sales work best when you think the price will go down either immediately or significantly enough to cover the dividend payments you’ll have to make.
4. Investors react strongly to bad news.
When a catastrophic story hits the news, investors often panic and want to start selling their investment. According to the efficient market hypothesis, once the news hits it may already be too late to profit. Assuming that the hypothesis is at least partially flawed, investors can still make good money by immediately short selling the asset. If it looks like the worst may be yet to come, you may be able to profit from bad news or a bear market.
5. You must meet margin calls.
When you borrow from a broker, you must maintain a certain equity percentage in your account. This amount varies by broker, but if you fall below it, your broker will force you to put more money in your account. Essentially, you have to keep enough collateral in your account to cover a portion of your potential losses. You need to have cash on hand and be willing to sacrifice some liquidity if you want to sell short.
6. You MUST return the security.
While the terms of short selling are indefinite, you have to close the position by returning the security sooner or later. Daniel Drew’s famous quote clarifies this inevitability: “He who sells what isn’t his’n, must pay it back or go to pris’n.”
Short selling isn’t necessarily a bad strategy. However, investing is already a dangerous game, and betting against a public company can be even more dangerous. It’s considerably riskier than buying a security and holding onto it. Responsible short selling requires three things: strong experience in the market, extreme confidence that the asset will decline in value, and strong investment risk tolerance.
Have you tried a short selling strategy? Share your success stories or the traps that kept you from making a profit.