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Short Selling Risk

The concept of short selling is a fairly simple - you borrow a stock, sell it, wait for its price to drop, and then buy it back at the lower price to return it to the lender. As simple as it may sound, short selling has its risks and you should be aware of them.

  • History has shown that in the long term markets trend upwards.

    This means that shorting is in a way betting against the market trend. Thus, if you initiate your trades with the idea of long-term sell and hold, you will face the risk of your stock going up in price instead of the desired downward direction.

    However, you can take advantage of the market's downward cycles, which tend to occur much faster than its run-ups. During bear markets most stocks go down and it can be less risky to go short than to own stocks long during these periods.

  • When short selling, the losses can be unlimited.

    After all, a stock cannot go below 0, so when you go long your losses are limited. Theoretically, a stock is not limited on how high its price can go. Thus, your losses can be infinite (theoretically).

    However, in reality this risk is limited to how far a stock may move in the wrong direction before the investor gets the chance to exit the trade. In order to protect yourself from substantial losses it is a good idea to have some sort of a stop-loss strategy.

  • Margin trading is always riskier.

    Short selling stocks includes margin trading. Just as with going long on margin, selling short on margin can significantly increase your losses.

  • Short selling includes the risk of a "short squeeze".

    When many short sellers try to cover their positions at once because a stock price has started to rise, this can drive the prices up even further. This is known as a "short squeeze" and can make you lose money very fast.

As you can see, while short selling does provide an opportunity to profit in a bear market, it also has some serious risks and therefore should be used only by advanced traders and sophisticated investors.

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