What Is Short Selling and Should You Do It?

Conventional investing involves buying and holding financial securities in hopes that their value will grow over time and profiting from price appreciation.

But there’s another strategy in which you can profit from stocks expected to underperform by betting on a decrease in their market value.

Traders who seek out companies and to capitalize on their predicted downfall engage in short selling. There are usually more opportunities to short securities in a bear market because the stock market grows in value over the long term.

This year has faced unprecedented uncertainty, and short sellers are taking advantage of that. Following the release of an incriminating report from Hindenburg Research accusing Nikola Corp (ticker: NKLA) of fraud, traders exploited the news for profit — the stock plummeted and was downgraded by analysts. Looking at Tesla’s ( TSLA) valuation, it can be argued that the stock is overvalued. TSLA is up more than 450% year to date, which has led traders globally to bet against it.

The high risks associated with short selling can come with high rewards. Famous short seller Jim Chanos of Kynikos Associates in New York City pocketed $100 million by shorting German fintech company Wirecard.

As it’s in the name, short selling tends to be a strategy executed in the short term as prices can change unexpectedly. Short selling is not the most popular practice since it engages with speculation. Short selling accounts for a segment of market activity with small upside and bigger downside. The following is a guide that describes this controversial market strategy:

— What is short selling?

— Why do investors short sell?

— How to manage short selling risks.

— Knowing the effect on stocks and the broader market.

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What Is Short Selling?

Short selling is the act of traders attempting to profit from the decline of a security’s market price.

This could be a stock, exchange-traded fund or real estate investment trust; mutual funds cannot be shorted. In a short selling scenario, if traders anticipate a security will underperform in the near term, they will sell borrowed stock at its current market value and then buy it back at a later date when and if the price drops, profiting off the difference.

Shorting flips traditional investing on its head. The investing methodology most investors follow of buy low, sell high is tossed out — or rather approached in reverse. Once you identify a short selling candidate, your broker finds and borrowers the securities from another investor who has the shares on your behalf.

The trader sells the borrowed security shares they don’t own, waits for the share price to decline and buys shares back at a lower price. Traders are charged interest on the borrowed stocks in a short sale. Once the short sale is complete, the trader returns the borrowed shares to the broker, who collects fees and any interest, and the trader rounds up any remaining profits.

To short a stock, you can open a margin account with your broker to enable borrowed stocks. Traders typically need to have at least 50% of the cost of sale that you borrow in your margin account before making the trade. There is often a margin account maintenance fee, which is usually about 30% of the equity’s value; the amount is set by your broker.

Trading on margin, or debt, can quickly go south. When the price of a company’s shares declines, the value of your short position increases and the money in a trader’s margin account increases. When the price of shares increases, the inverse occurs. Short selling on margin can result in losing money quickly and realizing more losses than you invest.

Why Market Participants Short Sell

Long-term investors and traders engage in short selling as another way to gain profits.

If they observe that a company’s fundamentals do not support its market value, they may speculate the security’s price is pointed toward a decline and take advantage of the downward trend.

Market participants may also short sell to protect their long position against downside risk. With stock market swings, various securities could decline, so investors can short stocks to safeguard against losses.

“During periods of high volatility such as we have experienced in recent years, it often makes sense to have a combination of long and short positions,” says Steven Jon Kaplan, CEO of True Contrarian Investments in New York City.

Depending on the ebbs and flows of the market, investors try to capitalize on market movements whether the value of securities owned goes up or trends down. Kaplan says that can be done by having both long and short positions.

“This involves buying whatever is most undervalued and selling short whatever is most overvalued. Whenever the market moves up, if you have selected your positions well, your long positions will often gain more than you are losing on your short positions,” he continues.

“Similarly, when the market is moving lower, the most overpriced stocks will often drop more than the best bargains,” he says. “That way you can make money on both up and down days.”

[See: 7 Alternative Investments That Might Fit Your Portfolio.]

How to Manage Short Selling Risks

In a typical investing scenario, when you are long on a stock, the most an investor can lose is the amount that was paid for the security. In a short selling scenario, if the stock’s price appreciates, this can result in losses parallel to the rise of the stock’s price.

“Shorting stocks is a very specialized investment strategy that very few investors are very good at,” says Andrew Wang, managing partner at Runnymede Capital Management in Mendham, New Jersey.

The basic risk with short selling is the danger of the security’s price increasing when you want it to decrease, which could provoke extensive losses for the short seller. Losses can easily be greater than gains. To put this in perspective, if a trader wants to short stock at $40 per share and the share price goes to zero, then that investor will gain $40. If the share price increases to $90, that would be a loss of $50, and if the share price increases even more, losses will accumulate.

“The mathematics of short selling are pretty hard. The most you can make on a short is 100%, so you don’t really have the miracle of compounding,” Wang says. “There’s a limited amount you can make but a potentially unlimited amount that you could lose.”

This is why it takes experience and skill to handle profitable short sales and to properly hedge risk, and it’s recommended that beginners stay away from short selling.

To form a well-rounded judgment on a stock to short, traders must do research on the company and the influencing factors of the depreciation of a stock to know when to execute a short sale. They also must understand the broader market dynamics and be aware of all the possible consequences.

Short sellers can hang on to the sale as long as they can afford its expenses. The longer traders hold on to a short position, the more fees they will have to pay to their broker — and the more interest will be charged on their margin account.

Wang adds that the market participants should consider factors other than valuation. “You cannot short a stock strictly based on valuation because overvalued stocks can remain overvalued for a long time. When shorting a stock, you must also identify a catalyst or rationale for why you think the stock may go down in the near term,” he explains.

To minimize short selling risks, consider having an exit strategy on your position before going into a short sale transaction. Determine how much money you’re willing lose. If you approach that threshold, consider putting in a buy stop order that places a stop price at a predetermined market price or a trailing buy stop order, in which the stop price is a percentage or set dollar amount above or below the stock’s current market price. These market orders on short sale transactions can prevent you from incurring too much loss or to protect profits.

[SEE: 7 Cheap Tech Stocks With Big Upside.]

Short Selling Effects on Stocks and the Broader Market

Short selling gets a risky reputation, but it can serve to check and balance the markets.

For example, if a company is a part of a scheme or fraud, short selling could uncover bad actors and maybe expose financial coloring.

There have been situations in the past in which short selling activity manipulated stock prices and shorting intentionally distorted or generated bad news about a company. “Short and distort” schemes have seen short sellers attempt to spread misinformation about a company to artificially drive down its valuation and mislead investors, but the U.S. Securities and Exchange Commission regulates this illegal activity and will hit any bad actors with a hefty fine.

Peter Davies, CEO of Jigsaw Trading in Bangkok, says short selling impacts the market the way it should: “It helps to drive prices down, usually because they are considered to be less valuable.”

“People trade the markets because of what they think will happen to prices,” Davies explains. “The idea that only people that buy stocks are good and that people that short them are bad is odd. They are both risking money based on their opinion of the market.”

More from U.S. News

5 Stocks to Sell or Stay Away From in October

8 Upgraded Stocks to Buy in October

8 Hedging Strategies for a Potential Stock Market Correction

What Is Short Selling and Should You Do It? originally appeared on usnews.com

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