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Short Selling a Stock: What You Need to Know About the Risks Involved

Have you ever wondered how you could make money on a falling stock? Well, there are many methods that hedge funds and seasoned stock market traders use to achieve this. The easiest way to do so, however, is by simply short selling a stock.

In essence, investors who short sell a stock are looking to profit when shares of the company depreciate. They do so by borrowing stock they do not own and selling it on the open market. When prices decline in value, they can then buy the shares and return it, earning the difference between the sale price and the purchase price.

Short selling research companies who are looking for potential candidates to short have recently been scrutinising the Singapore market. Because of this, Monetary Authority of Singapore (MAS) has proposed new rules to increase the “transparency” of these short positions to keep investors more informed.

In light of this, I have decided to assess the risks of short selling and whether this should be a strategy that individual investors employ.

Unlimited losses, limited upside

There can be many reasons for shorting a stock. Some of which can include overpriced shares, fundamentally flawed companies, weak management or a weak balance sheet.

However, investors who short a stock need to realise that unlike traditional buy (or long) positions in a company, shorting a stock can lead to losses greater than the invested capital. Profits, on the other hand, are capped at 100% of capital invested.

This is because a stock can potentially increase in value infinitely, but the most it can decline in value is just to zero.

For example, if you decided to short Company X at $10 per share and the price instead went up to $30 per share. You would have lost $20 on a $10 investment, which is 200% of your capital.

The Short Squeeze

Traders and investors tend to act as a group. This sort of herd mentality can create huge fluctuations in the stock market.

A short squeeze occurs when a company that has a high percentage of short interest suddenly goes up in value because investors are closing out their short positions at the same time. This can happen because of company news, triggering of stop loss positions or traders manipulating the market on an illiquid stock.

If you are holding on to a short position and a short squeeze occurs, the sudden surge in price can lead to very painful losses. A short squeeze can also trigger a stop loss and automatically close a position at a heavy loss.

Fees and dividend payment

Unlike traditional investing in stocks, where shareholders can earn dividends, short sellers do not earn any dividends. On top of that, short sellers need to pay the dividends to the owners of whom they have borrowed the stock from, in the case of a dividend payout.

This adds additional cost to holding a short position, on top of fees that brokerages charge to short sellers.

The Foolish Bottom Line

Short selling a stock is a strategy that many hedge funds employ to hedge against a bear market. It is also useful for investors who spot companies that are trading way above their fair valuation.

However, short selling does come with many potential risks and downsides. Stocks, in general, also tend to trend upwards, which means in the long run, short selling a stock is going against the general direction of the stock market.

Before deciding to use short selling as an investing strategy, investors should be aware of all the potential downsides and risks involved.

Meanwhile, for more (free!) investing opportunities, sign up here for your FREE subscription to The Motley Fool's investing newsletter, Take Stock Singapore. It will teach you how you can grow your wealth in the years ahead.

The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Jeremy Chia doesn't own shares in any companies mentioned.