Short selling has a number of risks that make it highly unsuitable for the novice investor. This strategy has a skewed payoff ratio in that the maximum gain (which would occur if the shorted stock was to plunge to zero) is limited, but the maximum loss is theoretically infinite (since stocks can in theory go up infinitely in price). If that prospect alone is not enough to deter the novice investor from making short sales, consider the other risks involved:
- Short selling involves significant expenses - In addition to trading commissions, other costs with short selling include that of borrowing the security to short it, as well as interest payable on the margin account that holds the shorted security.
- Dividend payments have to be made - The short seller is responsible for making dividend payments on the shorted stock to the entity from whom the stock has been borrowed.
- Risk of short squeezes and buy-ins - Stocks with very high short interest may occasionally surge in price. This usually happens when there is a positive development in the stock, which forces short sellers to buy the shares back to close their short positions. Heavily shorted stocks are also susceptible to “buy-ins,” which occur when a broker closes out short positions in a difficult-to-borrow stock whose lenders are demanding it back.
- Regulatory risks - Regulators may 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 cause a spike in stock prices, forcing the short seller to cover short positions at huge losses.
- Near-perfect timing is required - Unlike the “buy-and-hold” investor who can afford to wait for an investment to work out, the short seller does not have the luxury of time because of the many costs and risks associated with short selling. Timing is everything when it comes to shorting.
- For disciplined traders only - Short selling should only be undertaken by experienced traders who have the discipline to cut a losing short position, rather than add to it hoping that it will eventually work out.
The Bottom Line
While short selling can be a potent investment strategy for experienced traders and investors, it is not recommended for those with little experience or a low tolerance for risk.
Further reading: See our in-depth tutorial, "Short Selling."