When individual investors consider buying stock, they generally think long, buying those that they think will appreciate in value over time.
But short selling is different. Shorting a stock is a way to make money for those who think that the stock price will decline, and it is often viewed as a tool of sophisticated and advanced investors.
Numerous financial experts say that individual investors should never jump into short selling without a long history of buying and selling stocks.
So can individuals profit from what they think will be a stock decline, and what are the risks in acting on that belief?
For those who do plan to short a stock, what are some indications that a decline will occur?
First, let's go over how short selling works.
An investor borrows a stock from someone else at the current price and sells it for the stock's value. Then when the stock declines in value, the investor buys another at that lower price and gives it back to the lender.
The investor then pockets the difference between the amount the first stock sold for and the amount paid the second time.
As an example, let's say an investor buys a stock for $110 and then sells it for that same amount. If the stock then falls to $80, the investor can then buy it back for $80, give that stock back, and make a profit of $30.
On the other hand, if the stock continues to rise, then the investor loses money because he or she will need to spend more than $110 to get another share.
The classic problem with short selling is that unlike going long, it carries unlimited risk.
So if an investor buys a stock for $110, and that stock collapses to $10 in six months, the loss is $100. But if an investor shorts that same stock, and it balloons to $400, it is a $290 loss.
And theoretically, there is no limit to how much money can be lost on a short sale.
Furthermore, because the stock market as a whole generally goes up over time, the odds are in favor of a stock increasing instead of decreasing. Although this is of course speaking very generally, it does mean that building a long-term portfolio by shorting stocks isn't realistic.
Does this mean that individual investors should never short a stock? Not necessarily.
As MarketWatch investing columnist Phillip van Doorn observes, if a prominent professional shorts a stock, this could be a sign that investors should be concerned about a company's viability.
In other words, before even considering shorting a stock, conducting research on the company is absolutely critical.
Investors who want to short a stock don't need to find a company on the verge of bankruptcy. Instead, they can look for one that could take a temporary dip because it might miss quarterly earnings estimates.
There are some key things that investors should look at to decide whether a company's stock could decline. These include companies that are getting bad press, those undergoing accounting issues, or those where major insiders or shareholders are selling the stock.
Practicing short selling can have its advantages for an individual investor.
For starters, investors can learn to gain a better sense of when a company's stock will fall, which is just as important for long investing as short. Short selling can also teach the importance of thoroughly reviewing a company's numbers and news to understand whether it may face problems.
Short selling is riskier than going long, and any normal investor's portfolio should have more long stocks than short stocks. But saying that an individual investor should never short a stock under any circumstances is a stretch.
Those who have a history of buying stocks and are willing to conduct research on a company or industry may find short selling profitable.
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.