Short sales are intriguing to many investors because they allow you to play the downside of a company by reversing the order of the transaction so that you sell first, then buy later. Since all transactions must be resolved eventually, your portfolio will be “short” a given equity until you buy back to “cover” — hopefully at a lower price, creating a profit.
This is a deceptively simple form of trading, but the risks are significant.
For starters, short sales can only be made from a margin account that requires you to have a certain amount of cash in reserve to cover any trades. After all, it’s silly to think a broker would let you just “sell” as many stocks as you want and never worry about whether you could afford to eventually buy them back. As long as you make good trades you’ll be fine … but if you ever find yourself on the wrong side of a short sale, you might be faced with the dreaded “margin call,” where a broker insists that you either close the trade or front more money to prove you aren’t in over your head.
These events typically come at the worst time, since you are already in a bad spot on a poor investment and now the broker is knocking for cash you may not have. Do you sell just to get out, or do you scrape together the cash and hope for a rebound? It’s a stressful situation.
Another troublesome feature of short selling is that since you sell first, you have theoretically unlimited losses. For instance, if you buy a stock at $10, the worst it can do is go to zero and give you a 100% loss. But if you sell at $10, it could go to $20 and lose you 100% … or it could go to $21. Or $31. Or $131! Imagine covering a trade at $131 when you sold short at $10 — for a 1,300% loss. It’s rare, but it happens.
Still, if you have the discipline and research to short stocks effectively, it can be a powerful tool for profits. Most major brokers offer a way to sell short, but read the fine print on fees and margins because pricing will differ and could result in charges above and beyond a plain ol’ equities account.