3 risks to keep in mind when short selling stocks

Attractive opportunities for short selling stocks come along from time to time, but it’s a hard way to make money. That’s because short sellers face a number of unique disadvantages that don’t apply to buyers.

(See below for three risks to be aware of if you’re considering short selling stocks as an investment strategy.)

How short selling works

When you sell short, you borrow stock from a broker and then sell it. However, you eventually have to buy back the stock on the market to return it to its owner.

If the stock falls in price while you are “short,” you can buy it back at a lower price. You have then made a profit. But if the stock rises in price, you must buy it back at a higher price than you sold it, and you lose money.

Here are three important factors to be aware of when short selling stocks:

1. Your potential for loss is limitless: The main risk you face when short selling is that the returns are upside down. That is, when you sell short, your maximum gain is 100% (if the stock you’ve shorted goes to zero). But your potential losses are limitless. That’s the opposite of a regular stock purchase, where your gains are theoretically unlimited, and the most you can lose is 100%. You also have to pay for any dividends declared by stocks in which you have a short position.

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2. Current market conditions don’t favour short selling: If you’re interested in selling short, the best time to do it is when the market has been booming and investors are confident and have profits to invest. That’s when you find lots of stocks trading way above any reasonable estimate of value. But today, many stocks are still attractive, based on any reasonable assessment of their value. So it’s an especially bad time for short selling.

3. Buying puts can take the place of short selling, but puts require precise timing: Instead of short selling, some investors buy put options. These offer an investor the opportunity to sell a particular security at a specific price within a specific time frame. Like short sellers, put buyers make money when the investment in question goes down.

When you buy and sell puts, however, timing is crucial. If stock prices hold steady or rise, your puts can expire worthless. In addition, part of the value of a put or any option is based on how long it has left before it expires. As a result, puts (and stock options of all kinds) tend to lose value as time passes, even if the price of the stock holds steady.

Only take part in short selling stocks with money you can afford to lose

You may want to indulge in short selling from time to time, but we advise against doing so as a habit, mainly because of the increased risks of short selling over regular stock purchases. That’s why you should only take part in short selling with money you can afford to lose.

If you’re concerned about a market downturn, we think you’re better off converting some of your holdings to cash. This will hurt your portfolio’s potential for gains. But, unlike short selling, it won’t increase your risk.

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