As with most things in the financial markets, the answer is yes and no. Theoretically at least it is true that short selling is inherently riskier. A stock can go higher indefinitely (making your potential loss infinite at least in theory) while it can only go down to zero on the downside (limiting your potential profit to 100%). In reality though, things are a little bit different (and more short selling-friendly) because of the following factors:
- Although it is true that a stock has no limit as to how high it can get, in reality the value of a company (of which its stock price is a reflection, albeit one coloured by market psychology, overall trends, etc) will always be a finite number. This means that, although the payoff ratio for selling stocks short is asymetrical (you can lose more than you can make) in reality, the skew is not as pronounced, especially on a short-term timeframe.
- Your trading or investment strategy should include a position sizing strategy. This will make a devastating loss to your portfolio highly unlikely. A position sizing strategy will limit the risk that you take on every trade or investment by sizing it so that the maximum loss that any individual position can sustain is tolerable for your portfolio so that in the long run you can be profitable even accounting for the losing investments or trades that you will inevitably go through.
- Your short position should always include an explicit (at least in the beginning) stop loss price at which point your position will be closed out to prevent further losses. This will protect your capital in the long run (especially from the effects of one devastating trade or investment). In order to carry this out you can always place a buy to cover stop order at your stop loss price level. We'll talk about order types in a subsequent article.
- Since shorting happens on a margin account, your broker will issue a margin call and liquidate your position when your funds go below the minimum margin requirement. Because of this, you will only lose the money in your account and not an unlimited amount.
- The market is simply a reflection of several individual actions that market participants take in aggregate. On top of a fundamental and technical aspect, there is an emotional side to it so it is said that the market is driven by fear and greed; greed to make money and fear of losing it. Because of human nature, fear is the most powerful of the two so this results in the fact that normally (you will see this based on experience) markets fall much faster than they rise. Having the ability to short in your trading arsenal will allow you to take advantage of this and profit when the market is falling (rather than simply limiting losses which is the best a long-only portfolio can hope for in a falling market.
