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Short selling: Risks
Short selling: Risks
Authors: TradingDay.com, -oo0(GoldTrader)0oo-, Goodemi, OwenX, JJay, Pakaran
Publisher: TradingDay.com, Version: 1
Risks
Possibility of unlimited losses
It is important to note that buying shares and then selling them (called "going long") has a very different risk profile from selling short. In the former case, losses are limited (the price can only go down to zero) but gains are unlimited (there is no limit on how high the price can go). In short selling, this is reversed, meaning the possible gains are limited (the stock can only go down to a price of zero), and the seller can lose more than the original value of the share, with no upper limit. For this reason, short selling is usually used as part of a hedge rather than as an investment in its own right.
Many short sellers place a "stop loss order" with their stockbroker after selling a stock short. This is an order to the brokerage to cover the position if the price of the stock should rise to a certain level, in order to limit the loss and avoid the problem of unlimited liability described above. In some cases, if the stock's price skyrockets, the stockbroker may decide to cover the short seller's position immediately and without his consent, in order to guarantee that the short seller will be able to make good on his debt of shares.
No potential for dividend or interest income
Short selling is sometimes referred to as a "negative income investment strategy" because there is no potential for dividend income or interest income. One's return is strictly from capital gains.
Short squeeze
Short sellers must be aware of the potential for a short squeeze. This is a sharp uptick in the price of a stock, caused by large numbers of short sellers covering their positions on that stock. This can occur if the price has risen to a point where these people simply decide to cut their losses and get out. This may occur in an automated way if the short sellers had previously placed stop-loss orders with their brokers to prepare for this eventuality.
Since covering their positions involves buying shares, the short squeeze causes an ever further rise in the stock's price, which in turn may trigger additional covering. Because of this, most short sellers restrict their activities to heavily traded stocks, and they keep an eye on the "short interest" levels of their short investments. Short interest is defined as the total number of shares that have been sold short, but not yet covered.
On occasion, a short squeeze is deliberately induced. This can happen when a large investor (a company or a wealthy individual) notices significant short positions, and buys many shares, with the intent of selling the position at a profit to the short sellers who will be panicked by the initial uptick.
Overall upward direction of the market
Finally, short sellers must remember that they are betting against the overall upward direction of the market. This, combined with interest costs, can make it unattractive to keep a short position open for a long duration.
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This article uses
material from the Wikipedia article "Short selling" (Version
16:13, 12 September 2006) . It is licensed under
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