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If you've ever lost money on a stock, you've probably wondered if there's a way to make money when stocks fall. There is, and it's called short selling. Even though it seems to be the perfect strategy for capitalizing on declining stock prices, it comes with even more risk than buying stocks the traditional way.

How Shorting Works

The motivation behind short selling stocks is that the investor makes money when the stock price falls in value. This is the opposite of the normal process, in which the investor buys a stock with the idea that it will rise in price and be sold at a profit. Another distinguishing feature of short selling is that the seller is selling a stock that he doesn't own. That is, he's selling a stock before he buys it. To do that, he must borrow the stock that he's selling from the investment broker. When he does, he sells the stock and waits until it (hopefully) falls in price. At this time, he can purchase the stock for delivery, then close out the short position at a profit. You may be wondering what happens if the stock price rises and that's an important question. The seller can opt to hold the short position until the stock does fall in price, or he can close out the position at a loss.

The Math on Short Selling Risk/Reward Doesn't Add Up

A fundamental problem with short selling is the potential for unlimited losses. When you buy a stock in the usual way, you can never lose more than your invested capital. And your potential gain, in theory, has no limit. If you purchase a stock at $50, the most you can lose is $50. But if the stock rises, it can go to $100, $500, or even $1,000 which would give you a 20-to-1 return on your investment. The dynamic is the exact opposite with a short sale. If you short a stock at $50, the most you could ever make on the transaction is $50. But if the stock goes up to $100, you'll have to pay $100 to close out the position. There's no limit on how much money you could lose on a short sale. Should the price rise to $1,000, you’d have to pay $1,000 to close out a $50 investment position. This imbalance helps to explain why short selling isn't more popular than it is. Wise investors are aware of this possibility.

Time Works Against a Short Sale

There's no time limit on how long you can hold a short position on a stock. The problem, however, is that they are typically purchased using margin for at least part of the position. Those margin loans come with interest charges, and you will have to keep paying them for as long as you have your position in place. The interest charged functions as something of a negative dividend, in that it represents a regular reduction in your equity in the position. If you're paying 5% per year in margin interest, and you hold the short position for five years, you'll lose 25% of your investment just from doing nothing. That stacks the deck against you. You won't be able to sit on a short position forever. There's more news on the margin front, and it's both good and bad. If the stock that you sell short rises in price, the brokerage firm can implement a "margin call", which is a requirement for additional capital to maintain the required minimum investment. If you can't provide additional capital, the broker can close out the position, and you will incur a loss. As bad as this sounds, it can function as something of a stop-loss provision. As we've already discussed, potential losses on a short sale are unlimited. A margin call effectively put a limit on how much loss your position can sustain. The major negative on margin loans is that they enable you to leverage an investment position. While this works brilliantly to the upside, it simply multiplies your losses on the downside. Brokerage firms typically allow you to margin up to 50% of the value of an investment position. A margin call will usually apply if your equity in the position drops below a certain percentage, generally 25%.

Factors That Can Cause a Short Sale to go Seriously Wrong

No matter how bad a company's prospects may be, there are several events that could cause a sudden reversal of fortunes, and cause the stock price rise. And no matter how much research you do, or what expert opinion you obtain, any one of them could rear its ugly head at any time. Should it happen while you hold a short position in the stock, you could lose your entire investment or even more. Examples of such situations are mentioned below:

  • The general market could rise significantly, pulling up the price of your stock – despite the weak fundamentals of the company
  • The company could be a takeover candidate – just the announcement of a merger or acquisition could cause the price of the stock to skyrocket
  • The company could announce unexpected good news
  • A well-known investor could take a large position in the stock, on the opinion that it is undervalued
  • News could break of a major positive development in the company's industry that will cause the stock to rise in price
  • Political instability in a certain part of the world might suddenly make your short sale company more attractive
  • A change in legislation that affects the company or its industry in a positive way

These are just some examples of events that could unfold that could cause the price of the stock to rise, despite the fact that extensive research indicated that the company was a perfect candidate for short sale.

The Bottom Line

Investing in stocks in the usual way is risky enough. Short selling should be left to very experienced investors, with large portfolios that can easily absorb sudden and unexpected losses.

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