Promise and Risks of Short Selling

On the face of it it would seem unusual, no – illegal – that you can sell something that you don’t actually open but that is what a short sale is really all about. By definition, it is the selling of a stock or currency pair or index that you don’t own but rather borrow from a broker-dealer. Of course, you as the seller are obligated to buy the stock back in the future, and hopefully will have made some money on the deal. In a short sale, your hope is that the price of the asset you’ve “borrowed” for sale goes down, so that you can buy it back at a discount and profit from the difference.

A short sale is not a risk-free transaction by any means, as market prices have a funny way of being very unpredictable, and a rise in the stock price means you are going to repay the asset you borrowed and lose money in the deal; that clearly is the main disadvantage of a short sale. On the other hand, the primary advantage of one is that traders have the ability to profit from an asset’s drop in price. Because of the unpredictability of markets, experts always suggest ensuring that you have a Stop Loss order in place in case the price unexpectedly surges.

Short sellers have one other obstacle to surmount besides market unpredictability and that is trend. Historically, markets have move higher over time, and that works against a trader profiting from a broader market decline because a trader with an open short must move quickly to capture his profit or to halt his loss. Too, impending bad news tends to be built into market prices thanks to analysts’ forecasts, thus a trader with a short position must be ready within minutes of a news release to take advantage of the knee-jerk response before the markets reevaluate the news.

Traders who are interested in short selling must first try to gauge the impact not just on data releases and fundamental news, but extraneous events that could affect or mitigate the initial impact.

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