Our mothers always told us not to sell ourselves short. Mum's point was that we shouldn't underestimate ourselves. But when you sell a stock short, you're saying that other investors have overestimated the stock. 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.
But wrongly 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 that its price will rise and you will be able to sell it for a profit. If you take a short position in a stock, however, you think just the opposite--that the stock will be going down, and you want to 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. On your behalf, your broker borrows 1,000 shares of BP from another investor and then sells the stock, 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 (the £5,800 sale minus the £2,900 purchase), less whatever you have to pay for the broker's services. Not bad. And you thought your stocks had to go up to make money in the market.
The risks of short selling
Short selling has its problems, though. For starters, your profit potential is limited. That's because the stock's price cannot drop below zero. (Remember, you're betting that the price of the stock will fall.) When you take a long position in a stock, your profit potential is limitless; there's no ceiling for a stock's price.
The biggest risk, however, is losing your shorts. If you sell short and the stock price goes up instead of down, you're still obligated to replace the shares you borrowed--but you must now pay a higher price for them. The stock market goes up more often than it goes down. As a result, the short seller faces a rough road.
The other risk has to do with the possible magnitude of losses. When you sell short, your losses are potentially unlimited. If you take a long position, the worst you can do is lose your investment.
Say you bought (or went long) 1,000 shares of BP for £5.80 per share. If the company went bankrupt, you would lose your original investment, £5,800.
But say you shorted BP by borrowing 1,000 shares and selling them for £5.80 per share. You've netted £5,800 from the sale. The stock soars from £5.80 per share to £15.00. You have to buy back the shares, and it'll cost you £15,000. In the end, you've lost £9,200. And because there's no upper limit on how high stock can climb, theoretically there's no limit on your losses, either.
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.
For example, until 1995, American fund Liberty Special had an impressive record, beating both its peers and the S&P 500 index in most years. Then manager Jim Crabbe put his shorts on: He thought many technology stocks were grossly overvalued, so he shorted names such as Dell Computer, Compaq Computer, and America Online (AOL). He kept some of those short positions going through 1998, with disastrous results: The fund lost 43% that year.
If professional money managers can get it that wrong, what makes you think you can't?
For more investing classroom lessons on equities, bonds, funds and portfolio management, check out our Learning Centre.
