The Long and Short of Short Selling

You like to think of yourself as the fish that swims against the flow and makes it. When everyone else head to the right, you go left. You're the Kansas City shuffle personified but not as ruthless as people often assume. If you happen to be a stock market player, you're probably short selling right now.

The basic idea behind short selling is to make a profit as stocks go down. When the market goes bearish, you'd make a killing. So this is how it works: you borrow a stock from a broker and sell it. As the value of that stock goes down, you buy it back at a much lower price and keep the difference. The key here of course is to choose a stock that you think will drop in value. This is the opposite of going long, or the traditional investment strategy of buying a stock with the expectation that its price will eventually go up.

Short selling requires just as much research and analysis as going long. Short sellers need to pick a stock which is overvalued, meaning that the price of that stock doesn't accurately reflect the financial strength of the company. The high stock price may be the result of an enthusiastic buying spurt, a scam, a cover-up, or other reasons besides actual company growth. In this situation, it's only a matter of time before the stock price drops.

Another option for short sellers is to choose a high-priced stock of a big company that's on the verge of tanking. Examples of these are the stocks of Northern Rock and Bear Stearns. From a stock price of 12 British pounds, Northern Rock dropped to 2 pounds in just seven months. Bear Stearns posted a more precipitous drop; from trading at $172 in January 2007, it fell to $93 in February 2008 and plummeted to a staggering $2 per share a few weeks later. As crestfallen shareholders scrambled to salvage whatever was left of their investment, short sellers were raking in profits.

For obvious reasons, short sellers aren't exactly the most beloved people in the market. They have long been vilified as unscrupulous investors who plot to make stocks and companies crash. When stock prices go on a free fall, short sellers are one of the automatic villains. Although some traders do engage in unethical practices, it's not fair to lay the blame entirely on short selling since a lot of factors at play cause stocks to drop in value.

In fact, short selling plays an important role in balancing out the stock market. It deflates overpriced stocks, helps in maintaining liquidity, and provides a sobering factor in an otherwise surging bull market. An economy can overheat if it grows too fast and this will result in a much more painful downfall.

Short selling may be an attractive venture especially at a time of economic recession but it has its own set of dangerous risks. Novice investors are advised to tread carefully or better yet, to just steer clear. The losses in short selling is theoretically infinite. The lowest a stock price can drop to is zero while its increase can go above and beyond. So while the most a short seller can earn is 100 percent if a company goes poof, his losses may very well be insurmountable if the stock shoots up into space.

Another concern is when a stock has too many shares held short. If the price goes up, short sellers would then start selling their shares and this in turn would drive the price further upward and result in more losses. This is why it's not a good idea to short sell on a stock with a high short interest. Probably the most common pitfall of short selling is choosing the right at the wrong time. You may have picked an overvalued stock but it could take a while before its price drops. As you wait for its fall, you could get hit by interest, margin calls, or a demand of your broker to return the stock you borrowed.

Short selling is another investing strategy you can add to your portfolio. Just like any other investment though, it has its own set of benefits and risks that you have to consider. If you'd like to be a fish that swims against the flow, just make sure that you can stand the current.