Sunday, December 22, 2013

The Worst Thing about Shorting Stocks

Selling a stock short is the accomplished by borrowing a stock, selling it, and buying it back (known as “covering”) in hopes that the stock price will decline during that period. 

Most people who trade a lot of stocks will have some short positions.  Since stocks go up and down, it is certainly possible to make money by shorting.  There are also stocks that, at least in appearance, are good short candidates.  A stock like Blackberry $BBRY is often considered a good short candidate, because it is losing market share.  Short sales always take place in margin accounts.

One bad thing that can happen is that a trader can be wrong, and that the price will go up after the short and not come down, at least as long as the trader is willing to hold the short.  There is even the dreaded short squeeze, where the stock will go up suddenly and those holding shorts will be forced to buy the stock to cover, and end up driving the price even higher. The short seller has the potential for infinite losses!

These are very bad things. 

But the worst thing about shorting, in my opinion?  It’s that even if the trader is absolutely, exactly, 100% correct about making the short sale, the most he can do is double his investment.  If he shorts 100 shares of a $50 stock, and puts up $5,000 in margin, the most he can make is $5,000.   

Contrast that with buying a stock, where the investment can double, triple, or technically grow to infinity.  Money can be made both on the long and short side, but it is a lot harder to succeed with shorting.  You have to win a lot more often. 

This post is informational, and not a recommendation to buy (or short) securities.  

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