Short Selling And Why It Might Not Be A Good Idea

Short selling takes investment from being a business strategy to just being a gamble. You might win, but you could also lose a ton.

Short selling is one of the strategies employed by investors who are interested in making quick bucks in the stock market. By definition, short selling involves selling an asset or investment instrument that has been borrowed.

The short seller sells the borrowed assets it to a buyer at the current market price at that time thereby opening a position. You get to make a profit from short selling if you buy back the shares at a lower price.

The usual way to gain is to buy at a low price and sell at a high one, but short selling involves you doing the opposite. For you to be able to short sell, you must be able to borrow shares and before you can borrow, you have to open a margin account. This is the account that allows you to borrow money from the brokerage firm using your investment as collateral.

Putting it in perspective, assuming an investor believes the price of the shares of a company would go down, he or she would borrow say 500 shares on the basis that he would return the shares over the period of a week. He would then sell at the prevailing price; let’s assume it is N10 per share.

If the share price falls to like N8 within that one week, he quickly buys the same 500 shares at this cheaper price and returns the shares back to his broker. This is a buy-to-cover order. In that short period, he would have made a return of N2/ share which in this case is N2 multiplied by 500.

If you hadn’t heard about short selling before, you would probably wonder why your investor friends haven’t already shown you the way. The truth is that as exciting as short selling seems, it can work so very wrong.

The first and most apparent disadvantage is that if after a week, like in our example, the price climbs to N15, you would have made a huge loss. You don’t just lose your original investment; you have to pay even more.

It is said that with short selling, your losses are unlimited at least theoretically as you can lose more than you initially invest. This is because the higher the stock price goes, the more you stand to lose.

If the price increases out of proportion, you have to buy it at that price to return the stock to your broker. In the grand scheme of things, short selling can force a company to go bankrupt and it is said to be part of what caused the stock market crash of 2008.

Another very apparent disadvantage is that short selling takes investment from being a business strategy to just being a gamble – almost like a Ponzi scheme of its own sort. Stocks generally tend to appreciate in price and so companies do everything it takes for their values to increase.

You betting on their downfall is just going the opposing direction. The forces are typically against you. Even if you are right at some point, it might be the wrong time.

Finally, the profit might not be worth it at the end of the day as the action of short sellers might be counterproductive. There could be a short squeeze! A short squeeze is a situation where prices are going up, and the short sellers rush to quickly buy stocks fast to cover their positions. This in turn leads to an increased demand, further driving the price up.

The bottom-line is that short selling is a bad idea for the investor. It is always better to avoid investment strategies that time the market or are too short term based. A good investor would wait, and the wait would always be worth it.

Written by Lawretta Egba.