What is selling short
Selling short means selling something you do not yet own. If you have a margin account at a brokerage, you have this capability.
For instance, if you felt the stock of company X was likely to drop, and you did not own it, you could still sell it at the current price. Your brokerage firm would borrow shares on your behalf, send them to the buying party and put money from the sale into your account. You can use that cash as if you deposited it yourself; it is a real asset.
However, you now also have a real liability as you owe shares of company X stock. To eliminate this liability, at some point in the future you must buy the same number of shares of company X stock. Upon purchase, you will have profited if the price is lower than when you sold it.
Why you should not sell short
Against historic price trend
In general, the stock market rises as the population grows and the economy expands. The Standard & Poor’s 500, an index based on the stock price of 500 of the largest publicly traded corporations, crossed the 100 mark in 1968, 250 in 1986, 500 in 1995, 1000 in 1998, 1500 in 2007, 2000 in 2014, and 2500 in 2017.
In Figure 40-1, you can see how $1,000 invested in stocks grew during each 20-year span from 1938 to 2017. The worst of these 20-year periods saw gains of nearly 400%. Taking on positions that profit only when the market drops has historically been a losing proposition.
Market timing does not work
Though the market generally rises, downdrafts do occur. Unfortunately, declines are usually quick, dramatic, and unpredictable. Since selling short is a definite loser over long spells, it can only be viewed as a short-term, market timing mechanism. As demonstrated in, trying to time markets is foolish and potentially devastating to returns.
Unlimited potential loss
When you take a short position, your potential loss is theoretically infinite. After you have sold something for a set price, you have already received all potential proceeds. Going forward, if the stock price goes up, you will have to spend more money to buy it than you received selling it. If the stock doubles, you will spend twice as much and experience a loss equal to 100% of your original sale. If the stock triples, you will have to pay three times your original proceeds; and so on.
What you should do instead
If your temptation to sell short is a matter of trying to time the market, ignore the urge and stay invested at the level appropriate to your risk tolerance.
If your desire to sell short is due to a new level of concern, adjust your asset allocation instead. Do not take on a bad position, ever. Replace good volatile securities (stocks) with good stable securities (bonds, cash). When your concern abates and your tolerance for risk returns to its normal level, switch your holdings back.
* Data source:
S&P Dow Jones Indices LLC; Standard & Poor’s 500 Index