The Risks

Now that we've introduced short selling, let's make one thing clear: shorting is risky. Actually, we'll rephrase that. Shorting is very, very risky... not unlike running with the bulls in Spain. You can have a great time, or you can get trampled.

You can think of the outcome of a short sale as basically the opposite of a regular buy transaction, but the mechanics behind a short result in some unique risks.

1. History has shown that, in general, stocks have an upward drift. Over the long run, most stocks appreciate in price. For that matter, even if a company barely improves over the years, inflation should drive its stock price up somewhat. What this means is that shorting is betting against the overall direction of the market.

2. When you short sell, your losses can be infinite. A short sale loses when the stock price rises, and a stock is (theoretically, at least) not limited on how high it can go. On the other hand, a stock can't go below 0, so your upside is limited. Bottom line: you can lose more than you initially invest, but the best you can earn is a 100% gain if a company goes out of business.

3. Shorting stocks involves using borrowed money, otherwise known as margin trading. Just as when you go long on margin, it's easy for losses to get out of hand because you must meet the minimum margin requirement. If your account slips below this, you'll be subject to a margin call –you'll be forced to put in more cash or liquidate your position. (As mentioned earlier, we won't cover margin details here because we have an entire tutorial devoted to it.)

4. If a stock starts to rise and a large number of short sellers try to cover their positions at the same time, it can quickly drive up the price even further. This phenomenon is known as a "short squeeze." Usually, news in the market will trigger a short squeeze, but sometimes traders who notice a large number of shorts in a stock will attempt to induce one. This is why it's not a good idea to short a stock with high short interest. A short squeeze is a great way to lose a lot of money extremely fast.

5. The final and largest complication is being right too soon. Even though a company is overvalued, it could conceivably take a while to come back down. In the meantime, you are vulnerable to dividends (which you would have to pay), margin calls, and being called away. Academics and traders alike have tried for years to come up with explanations as to why a stock's market price varies from its intrinsic value. They have yet to come up with a model that works all the time, and probably never will.

Take the dot-com bubble, for example. Sure, you could have made a killing if you shorted at the market top in the beginning of 2000. But many believed that stocks were grossly overvalued even a year earlier. You'd be in the poorhouse now if you shorted the Nasdaq in 1999! This is contrary to the popular belief that pre-1999 valuations more accurately reflected the Nasdaq. However, it wasn't until three years later, in 2002, that the Nasdaq returned to 1999 levels.

Momentum is a funny thing. Whether in physics or the stock market, it's something you don't want to stand in front of. All it takes is one big shorting mistake to kill you. Just as you wouldn't jump in front of a pack of stampeding bulls, don't fight against the trend of a hot stock.