What Are the Risks of Short Selling

Short selling allows you to sell a security without owning it. (Doing so for virtually everything other than stocks, can land a person in prison!) If a stock’s price falls below its short-sale price, you make a profit.

If the stock price increases, however, you can lose money. The potential loss is limitless because if the stock keeps going up, the amount of the loss increases. Suppose that you thought that certain Internet stocks were overvalued during their period of “irrational exuberance” and decided to sell some of them short. Tremendous losses would have resulted during the wild inflation of prices. AOL stock (now part of Time Warner) went from $100 to about $400 per share on a presplit basis in a short period. If you had sold short at $100 and had not covered your position (bought back the stock), you would have faced the prospect of buying back the stock at an enormously high price, resulting in a large loss per share. With a long position, the most that you can lose is the amount of your investment (buy a stock at $12 per share, and it falls to $0), whereas short selling imposes no limits. The higher the price, the greater is the loss. Stocks generally appreciate over time, which means that by selling short, you are betting against the trend of the market.

Stocks that have a large number of short positions incur additional risk when the stocks rise in price. Short sellers rush to buy back the stocks to cover their positions, which drives prices up, further resulting in a short squeeze in the stock. Technically, it is risky to short a stock with large short positions (short interest).

You have to be aware of other risks. Stocks can be sold short only if the price of the stock on its preceding trade was traded on an uptick or a zero-tick. An uptick means that the price of the existing trade exceeds the price of the preceding trade. Azero-tick means that the price of the most recent trade is the same as the preceding trade. Thus, if the price of a stock declines precipitously, your short sale might not be executed.

The short seller is also required to pay any dividends that are declared by the company to the owner of the borrowed securities. In addition, the proceeds of the short sale are held as collateral for the securities borrowed by the brokerage firm. The short seller is also required to provide additional funds (the margin requirement of 50 percent set by the Federal Reserve). If the stock remains in a flat trading range, the short seller’s funds and the margin requirement are tied up in the account.

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