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Investor Toolkit: The very high risk of short selling stocks

short selling stocksEvery Wednesday, we publish our “Investor Toolkit” series on TSI Network. Whether you’re a new or experienced investor, these weekly updates are designed to give you specific advice on successful investing. Each Investor Toolkit update gives you a fundamental tip and shows you how you can put it into practice right away.

Tip of the week:
“With short selling, you have to balance the slim chance of making money fast against the greater probability that you will lose money—possibly a lot of it.”

There are plenty of references in the financial media to “shorts”—those seeking to profit from stocks that fall in price. But this strategy comes with considerable risk.

When you decide to sell a stock short, you borrow that stock from a broker and then sell it. But you eventually have to buy the stock back on the market in order 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’re obliged to buy it back at a higher price than you sold it, and you lose money.

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Short selling can make you money twice as fast as simply buying stocks. That’s because stocks tend to fall about twice as fast as they rise. But many “shorts” wind up losing money, because short selling lacks these three key advantages of investing in stocks:

The advantages of buying a stock

  • Advantage #1: Investors can earn income from dividends.
  • Advantage #2: Investors can usually hold on to their stocks indefinitely, and only sell when they wish.
  • Advantage #3: Time works in an investor’s favour, since well-managed companies tend to expand over long periods.

Three big disadvantages of short selling stocks

  • Disadvantage #1: Short-sellers don’t earn any income. Instead, they have to make good on dividends that the stock’s owner would receive. Right now, 2.3% is the average yield on the S&P/TSX 60 Index, which holds the bulk of Canada’s leading dividend stocks. So, on average, today’s short-sellers miss out on a 2.3% yield, and have to pay out that much to the stock’s owners, for an average disadvantage (compared to buying the stock) of 4.6% a year.
  • Disadvantage #2: Short-sellers can be forced to return shares they’ve borrowed with little notice, if the owner calls it in. If your broker can’t find a new stock to borrow, you can be forced to buy the stock back in the market. This may force its price up.
  • Disadvantage #3: Time works against you when you are short selling, because companies tend to grow over long periods.

Our investment advice: Above all, it’s important to remember that the odds in short selling are upside down. When you buy, your potential gain is unlimited, but all you can lose is 100%. When you sell short, your maximum gain is 100%, if the stock you short drops to zero. But a short-seller’s potential loss is unlimited, because there’s no telling how high a stock can go.

COMMENTS PLEASE&#8212Share your investment experience and opinions with fellow TSINetwork.ca members

Have you ever made money short selling a stock? Would you do it again?

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