Our mothers always told us not to sell ourselves short. Her point was that we shouldn’t underestimate ourselves.
But when you sell a stock short, you’re saying that other investors have overestimated it. You think it’s worth a lot less than they do. By short selling, you hope to benefit from a fall in the stock’s price.
Selling yourself short isn’t nearly as financially painful as wrongly selling a stock short. This lesson covers what short selling is, its risks, and why you shouldn’t bother.
What is short selling?
When you buy a stock, you’re taking what’s called a long position in the stock. You think its price will rise and you will be able to sell for a profit. If you take a short position in a stock, however, you are betting on the opposite – that the stock price will go down, and you will profit from the decline.
The upside-down version of owning the stock, or selling the stock short, involves borrowing the stock from another investor. You’re obligated to replace those shares in the future, but you hope to buy them at a lower price than they are currently selling for. So you sell the borrowed shares now in the hopes that the stock will decline. If the stock’s price does fall, you then buy the stock back at the lower price and return the borrowed shares.
Here’s an example. You think BP’s stock is overpriced at £5.80 per share, so you decide to short it. Your broker borrows 1,000 BP shares from another investor and sells them, netting you about £5,800.
Let’s say you were right about it being a poor investment, and the stock falls to £2.90 per share. Now you can buy 1,000 shares for just £2,900 and return them to your broker. You pocket £2,900, less whatever you have to pay for the broker’s services. Not bad. And you thought stocks had to go up to make mone.
The risks of short selling
Short selling has its problems, though. For starters, your profit potential is limited because a stock price can’t drop below zero. When you take a long position in a stock, your profit potential is limitless because there’s no ceiling for the price.
The biggest risk, however, is losing your shorts. If you sell short and the stock price goes up instead of down, you must now pay a higher price for them. The stock market goes up more often than it goes down. Also, when you sell short, your losses are potentially unlimited. If you take a long position, the worst you can do is lose your investment.
Why you shouldn’t bother
You may be thinking to yourself that we’re being a little dramatic. Surely it can’t be that hard to avoid getting burned that badly. After all, you can buy back the shares before they climb that high and limit your losses.
Maybe you can. But knowing just when to act is tough. Even the pros have been burned trying to short stocks.
If professional money managers can get it wrong, what makes you think you can do it?
Paul McLardie is a partner at Total Wealth Management. Contact him at Paul.firstname.lastname@example.org