“Short selling” (also known as “shorting,” “selling short” or “going short”) means the sale of a security or financial instrument that the seller has borrowed to make the short sale. The short seller believes that the borrowed security’s price will decline, enabling it to be bought back at a lower price. Short sellers make the markets function smoothly by providing liquidity, and also serve as a restraining influence on investors’ over-exuberance.
While “shorting” is fundamentally a risky activity since it goes against the long-term upward trend of the markets, it is especially dangerous when markets are surging. Short sellers confronted with escalating losses in a relentless bull market are painfully reminded of John Maynard Keynes’ famous adage – “The market can stay irrational longer than you can stay solvent.”
Short selling involves a number of risks, including the following:
Skewed risk-reward payoff
Unlike a long position in a security, where the loss is limited to the amount invested in the security and the potential profit is boundless, a short sale carries the theoretical risk of infinite loss, while the maximum gain – which would occur if the stock drops to zero – is limited.
Short selling involves a number of costs over and above trading commissions. A significant cost comes with borrowing shares to short, in addition to interest that is normally payable on a margin account. The short seller is also on the hook for dividend payments made by the stock that has been shorted.
Regulators may sometimes impose bans on short sales in a specific sector or even in the broad market to avoid panic and unwarranted selling pressure. Such actions can make a sudden spike in stock prices, forcing the short seller to cover short positions at huge losses.
Short Squeezes and “Buy-Ins”
A stock with very high short interest may occasionally surge in price—typically when a positive development in the stock or broad market triggers massive short-covering—creating a “short squeeze.”
Heavily shorted stocks are also vulnerable to “buy-ins,” which occurs when a broker-dealer closes out short positions in a difficult-to-borrow stock because its lenders are demanding it back.
Strict Trading Discipline Required
The excess of risks associated with short selling means that it only fits traders and investors who have the trading discipline required to cut their losses when required.
Holding on to an unprofitable short position in the hope that it will come back is not a practical strategy. Short selling requires constant position monitoring and obedience to tight stop losses.
Contrary to Long-Term Market Trend
As the long-term trend of the market is upward, short selling is a contrarian strategy. Unlike a buy-and-hold strategy, it has to be opportunistic and well timed.
Timing is Everything
The timing of the short sale is critical, since initiating a short sale at the wrong time can be a formula for disaster.
Short selling is a relatively advanced strategy best suited for sophisticated investors or traders who are familiar with the risks of shorting and the regulations involved. For those who know how to use it effectively, short selling can be a powerful weapon in one’s investing arsenal.
See Also: Short Selling to Your Advantage
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