Short selling is defined as the selling of a security that one does not own. Short sellers assume that they will be able to buy the stock back at a lower price than what they sold it for and make a profit. Short sellers make money when the price of the stock they short goes down. Short selling has become infinitely more popular in the past decade or so, with numerous people trying their luck in short selling, or shorting stocks.
When an investor decides to sell a stock short they must do so in a margin account. The investor will borrow money from their broker so that they can sell the stock short. Until July of this year, there was an uptick rule. The uptick rule meant that in order to short a stock an investor must wait for an uptick in the stock. The rule was abolished in July by the SEC.
Let's look at what I believe are some of the key advantages and disadvantages of short selling.
Advantages
- A great way to hedge a portfolio. Many investors can successfully use short positions to hedge their long positions.
- Gives you the ability to profit in a down market. Without short selling it can be difficult to profit in a very bearish market.
- It can sometimes be easier to find companies who are ripe for a fall than ones who are about to run higher, because of evident financial problems or strange insider activity.
Disadvantages
- There is no limit to how much money you can lose. When you sell a stock short it can rise to infinity rather than stopping at zero.
- When selling stocks short you do not profit from any kind of dividends or stock splits from the stock since you are betting against the stock and do not technically own the stock.
- You are betting against the direction of the overall market. You must remember that history shows stocks will rise over the long term, and you are betting against that principle.
- Since you short stocks in a margin account it is very easy for your losses to get out of hand. Your account is subject to possible margin calls, where you'll be forced to put more cash in your account or liquidate your position.
These are some of the major advantages and disadvantages of selling stocks short. I personally think that short selling of stocks is something that most novices should steer clear of. If you are very knowledgable about the market and how short selling works, some speculation and hedging using short selling can be beneficial. I do caution investors though, the long-term trend of the U.S. stock market has always been higher, be careful in fighting that trend too much.
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