Risk Management, Trading & Portfolio Strategies

How dangerous is short selling?

Short selling can yield big rewards - if done correctly.

Short selling can yield big rewards – if done correctly.

Short selling, which is essentially the act of betting on a drop in the price of a stock or asset, is only as dangerous as the size and scope of the gamble itself. Many investors build their entire careers on short selling – look at George Soros and his still-infamous wager that cost the Bank of England nearly $1 billion – while just as many others have lost their shirts on similar ventures. At the end of the day, short selling is truly playing with fire – it can be a successful act, if done correctly.

Depending on who you ask, there are a few inherent dangers involved with short selling that have to be reconciled. First and foremost, it's easy to assume that all agents in a given market are rational actors. This is fundamentally incorrect. Human beings are more than capable of severe irrationality, and this is acutely true for today's stock market. The slightest whisper of a doubt regarding a company's future health or development can send major stakeholders screaming toward the exits, leading to a precipitous drop in price that may wipe people out for good. On the other hand, rumors of a new product or service that will increase that firm's value can drive investors to pile in, thereby shooting the stock price up. It's these market movements that make short selling so complicated, which is why many experts recommend that novice short-sellers look for low-volatility opportunities.

Travis Hoium of The Motley Fool wrote recently that bets that seem sure-fire can fizzle out unexpectedly, thereby setting up investors for a bad day if they didn't do their homework correctly. Seasoned investors know that, if they decide to take this path, they need to engage in proper investigation to ensure that their call is on the mark.

One way of doing so is to utilize SmartStops, which are portfolio management tools capable of showing you how inherent risk levels can effect market performance. For example, SmartStops Risk Signals depict up and down rotations in price over a predetermined time cycle, allowing you to make more informed decisions based on where a stock price may be heading. Contact us today or explore our site further to learn more!

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