Pros and Cons of Short Selling Stocks

Making Money in an Trade even in a Down Market

Nov 28, 2007 James Hutchinson

The positive and negative aspects of betting against the stock market by shorting stocks.

Selling a stock short is a bet that the price of the stock will decline. It is the opposite of a long position, which involves investing in a company in the hopes the price of the stock will increase.

In a short position, the investor borrows the stock and immediately sells it. The proceeds from the sales are deposited into the investment account. The position is closed when the investor buys back the same stock (known as covering a short).

If the stock has declined since the sale, the investor makes a profit on the difference, less commissions. The goal is to sell high, and buy low.

Positives of Shorting Stocks

Although historically the general trend is for stock prices to increase, prices do fluctuate, and shorting can be used to make money when a stock is overpriced from too fast an increase or if the company itself is not competitive or is in a declining business.
In a larger portfolio of long investments, shorting can be a hedge against a large drop in the stock market.
Because the stock is borrowed and sold, cash is received, not disbursed, in the transaction. Cash needs to be in the account to meet margin requirements, but that cash can still be used to purchase other investments (up to the margin requirement) or will earn income in an interest bearing account.
Some accounts earn interest on the funds received from the sale of the short stock as well. Consult your broker for information on whether this applies to your account.

Negatives of Shorting Stocks

Because the price of a stock can potentially go to infinity, the possible loss on a short position is unlimited. In real world terms, a position can be closed before an infinite loss will occur, and will be closed if margin requirements are exceeded.
The maximum gain on any short is 100%. The price of a stock cannot go lower than zero. There are no five or 10-baggers in shorting.
As a borrower of the stock, the investor is responsible for paying for any dividends that are due while shorting the stock. The amount will generally be deducted from the investor’s account.
Not all stocks can be shorted. A broker must have the stock in its position to allow the investor to borrow the stock, and restrictions are also placed on some stocks with smaller available numbers of shares (float position).
The broker can mandate the closure of a short position at the current market price. If this occurs in large numbers, a “short squeeze” develops, which is a large price increase in a heavily shorted stock over a short time frame.

Is Shorting Stocks a Good Idea?

Shorting can be an effective way to add diversification to a portfolio. Investors need to take steps to limit losses by monitoring positions closely.

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