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What’s So Scary About Short Selling?

By Jason Markum

Investing in the stock market is one of the hardest things in the world, in my opinion. There are few things within the world of stock market investing that are as difficult for many people do understand as short selling. In fact most of the investing world tends to look on short-sellers as second-class citizens who are somehow profiting from the misfortune of others. But is this really the case?

Isn’t short selling just another investment strategy like all the others? The answer is yes. There is nothing inherently evil about short selling and there is certainly nothing unethical about it either.

Short selling is fraught with danger, in fact short-sellers take much greater risks than other investors day in and day out. The reason for this are ceilings. A regular investor has a ceiling on how much money they can lose. If I invest $100 in a stock and that stock goes bankrupt and hits zero dollars, then I’m out $100.

Short-sellers on the other hand have no ceiling on how much money they can lose on any given trade. If I bet that this stock is going to decrease and then sell short, and something happens and out of the blue that stock shoots up in price then my potential loss is as high as the share goes… and there is no limit. That stock can climb up $120 a share, or $150 a share or $100,000 a share! Does that sound far-fetched? Shares of Warren Buffett’s Berkshire Hathaway have often risen above $100,000 per share and it may be abnormal for a stock to raise that high but it certainly can happen which means there is no limit on the amount of money a short seller can lose, making them incredibly risky investments.

Fortunately we live in a world that is run by a system that rewards risk. The greater the risk the greater the potential reward… that’s just how the stock market works and there’s nothing evil about it as many people would suggest.

So why do so many people frown on short selling? I suppose it’s the notion that you are taking advantage of someone else’s misfortune. In order to make money as a short seller, a company stock has to go down in price. In fact you are betting just that. Some people have gone so far as to suggest that short-sellers cause a stock to drop in price when it otherwise wouldn’t.

How is this possible? Well if enough people start selling a stock short then word gets around and people start to wonder if there’s something wrong with the stock even if there isn’t a single thing wrong with it. In this way short-term market speculation can cause a stock to decrease the doesn’t necessarily deserve to decrease. Of course in the long run these things usually sort themselves out but in the short term they can cause havoc for a lot of different people.

However you feel about short selling, one thing is for sure… it’s here to stay no matter what.

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