What Is Short Selling? The Benefits and Risks Explained

Navigating the stock market during its bullish phases can be a rewarding experience for investors. 

The options are plentiful: you can either engage in quick trades to capitalize on market trends or adopt a long-term strategy, holding onto stocks and watching your portfolio appreciate over time.

However, when the market takes an unfavorable turn, what strategies can you employ to mitigate losses? 

One of the most popular and time-proven tactics is called short selling.

The Basics of Short Selling

Short selling is an investment strategy which investors employ when they anticipate a significant decline in a stock's value.

By borrowing shares from a brokerage firm, the investor liquidates them at the current market rate.

The endgame is to repurchase these equities at a lower price point, subsequently returning them to the lender and capturing the price differential as net profit.

An Example

To illustrate this strategy better, let's consider a hypothetical scenario involving an imaginary company we’ll simply call XYZ.

If you’ve analyzed the XYZ stock and believe it is overvalued and long overdue for a market correction, you could borrow a number of the company’s shares from your broker, for example 100 shares, which you immediately sell for the current market price of $100 per share and receive $10,000.

If your predictions about depreciation of the XYZ stock prove correct in the coming weeks, and the price per share declines to $80, you can then repurchase your 100 shares for $8,000, return them to your broker and realize a $2,000 profit.

This profit can then subsequently be reinvested in other assets that have a more promising outlook, allowing you to continue generating returns even in bad market conditions.

Benefits of Short Selling

Short selling offers several compelling advantages, namely:

• Profit in Bear Markets: This strategy enables you to make money when the market is in decline, thereby serving as a financial cushion for your portfolio.
• Opportunistic Buying: A market downturn often leads to lucrative investment opportunities. Short selling provides the liquidity to seize these chances.
• Hedging: If you hold a long position in a stock, shorting the same stock can act as a hedge against potential losses.
• Diversification: Incorporating short selling into your investment strategy adds an extra layer of diversification to your portfolio, mitigating overall risk and potentially increasing long-term returns.

How to Short a Stock

Embarking on a short-selling venture requires a few preparatory steps. First, ensure that your broker offers this service, as not all do. 

Once you've confirmed this, conduct meticulous research to identify a stock that is a prime candidate for shorting. 

Place your order with your broker once you've made your selection, along with a stop-loss order, which will automatically trigger a buy order if the stock reaches a predetermined price, thereby limiting your losses if the stock price unexpectedly rises.

Short Selling Risks

While short selling can lead to numerous benefits, it also comes with a high amount of risk. Predictions are still just that - predictions, and stock prices can easily go up right when you expect them to come down, which can lead to substantial losses.

You may also be required to pay interest on the borrowed shares, and by shorting a stock you always put yourself in the risk of a “short squeeze”, where sudden stock price increases forces other short sellers to buy back their borrowed shares, which then further inflates the price. 

This phenomenon was recently and most notably observed with GameStop in 2021, leading to significant losses for hedge funds that had shorted the stock.

Alternatives

If the high-risk nature of short selling doesn't align with your investment profile or seems too stressful of a strategy, there are safer alternatives to consider. 

• Bonds are an easy choice for a risk-free investor. You lend money to an issuer and receive periodic interest payments, plus the bond's face value at maturity. Bonds offer a predictable income stream and are generally less volatile than stocks.
• Dividend-Paying Stocks offer both potential for capital appreciation and regular dividend payments.
• Mutual Funds pool money from multiple investors to buy a diversified portfolio, managed by professionals. They offer risk mitigation through diversification and are available in various sectors and asset classes.
• Exchange-Traded Funds (ETFs) are similar to mutual funds but are traded on stock exchanges and offer the flexibility to buy and sell shares throughout the trading day hours.

What Is Naked Short Selling?

Naked short selling is an illicit practice where an investor sells shares they neither own nor have borrowed. 

This can lead to market manipulation and is illegal in many jurisdictions.

Short Selling Terms You Should Know Before Investing

• Short Position: This refers to the act of selling borrowed securities with the expectation of buying them back at a lower price.
• Short Covering: This is the process of buying back securities to close a short position, usually to mitigate losses.
• Short Interest: This metric indicates the number of shares sold short but not yet repurchased, serving as a barometer of investor sentiment.
• Short Squeeze: A rapid price increase causing short sellers to buy back shares, further driving up the price.
• Margin Account: An account that allows you to borrow funds for investment.
• Margin Call: A broker's request for additional funds when your account value declines.

Wrapping Up

Short selling can indeed be a highly lucrative investment strategy, but it is also one of the riskiest options available to you as an investor.

To reap the rewards and come out on top, you’ll need not only luck and a vast knowledge of the market, but also diligence in managing risk and minimizing your potential losses, and perhaps even the assistance of a professional advisor.