Now that we’ve established that short sellers aren’t evil incarnate, let’s talk about benefits and drawbacks.
Short selling involves more risk than traditional stock trading and successful traders use it as part of a larger overall strategy instead of a way of life.
Pro: Short sellers flock to frauds
Short selling growing and profitable companies makes very little financial sense. Short sellers by definition are looking for weaker stocks with shaky balance sheets, faulty products, or questionable decision-makers.
Sometimes they even find a combination of all three! By looking for stocks with elevated short interest, you might be able to find companies headed for a downturn.
Con: Potentially unlimited losses
When buying a stock, your maximum loss is the initial amount you invested – you can’t go below zero. But that’s not true for short selling. When you sell short, you’re borrowing shares and immediately selling them.
Then you wait for the decline before returning them to your broker. But what if the stock soars on news of being acquired and the share price doubles? Short sellers run the risk of losing more than they initially invest if the stock takes the elevator up instead of down.
Pro: Easier to hedge your portfolio
One of the most common uses of short selling is hedging a long portfolio in case stocks enter a bear market. Short sales are often used as “insurance” against market declines since the gains of the short will offset the losses of the portfolio.
Many traders also hedge stock purchases with put options to protect against downside risk.
Con: Bull markets are more common than bear markets
Short selling might sound exciting and glamorous, but it’s a money-losing move in most markets. The simple fact is that bull markets usually stick around longer than bear markets and shorts will inevitably find themselves on the wrong side of a few trades.
Stocks go up more than they go down; otherwise what’s the point of all this?