The Dangers of Short-Selling in an Uncertain Economy - dummies

The Dangers of Short-Selling in an Uncertain Economy

Before you start short selling your way to untold fortunes, you should know that short selling is a speculative strategy with significant risks and may not be appropriate for most investors.

History shows that stocks appreciate

Using history as a guide, the long-term trend for stocks is positive. Although the market drops or trades sideways (moves up and down within a limited range) at times, stocks have appreciated more than any other asset classes over long time periods. Although you have no guarantee that this trend will continue, be aware that short selling involves going against this powerful trend!

You risk unlimited loss for a limited gain

The potential gain from short selling is limited to the cash you receive from selling the stock, while the potential loss is unlimited. For example, if you receive $2,500 from selling XYZ stock, the most you could make from the transaction is $2,500, but XYZ would have to go bankrupt for you to be able to keep the entire amount.

But what happens if the price of XYZ stock begins to skyrocket after you sell the shares short? You’re responsible for purchasing the 100 shares of XYZ stock to close the short position no matter what the price!

Although an unlimited loss is really possible only in theory, be aware that the price could easily double or triple before you have the chance to repurchase the shares. This is especially true for stocks of small companies, or stocks that are thinly traded (which means they don’t have a high volume of shares that are regularly traded).

In this scenario, if the price of XYZ stock doubles after you sell short, you have to buy back 100 shares at $50 per share. You spend $5,000 to buy the same stock you sold for $2,500. You lose $2,500 and that’s before you add in commission fees and the interest you have to pay for the period of time until you close the short position.

You pay interest on losses

A margin account is required for short selling. If you sell a stock short, and the price of that stock begins to increase, your broker will move money from the cash balance of your account to cover the losses. A margin balance will be created if you don’t have sufficient cash to cover the position, and you’ll begin to accrue interest charges on the margin balance. So you could not only suffer a loss from your short position, but also end up paying interest for the privilege of losing money!