If you feel stocks have become overpriced lately, you might want to take advantage of this by short selling stocks — that is, selling borrowed shares in hopes of a drop in price. We advise against this strategy, mainly because of the perennial drawbacks of short selling.

Short selling is when 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.

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Your potential for loss is limitless when short selling stocks

Attractive short-selling opportunities do come along from time to time, but it’s a hard way to make money. That’s because, compared to buyers, shorts face a broad range of disadvantages.

For one, the returns on short selling stocks are upside down: 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 runs directly counter to 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.

Today’s market trends don’t favour short selling stocks

If you’re interested in selling short, the 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.

Timing is difficult with short selling, put options, and other similar tactics

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, timing is crucial and very difficult. If stock prices 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 moves in the option holder’s favour.

From time to time, some investors do profit from short sales, puts and other, similar tactics. But consistently successful investors stick with a system like ours (that is, buying high-quality stocks and diversifying across the five main economic sectors). This lets you profit more or less automatically from the long-term upward trend in stock markets.

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