Opinions on short selling have long been divided:

• Is the practice of capitalizing on market declines un-American, as many seem to believe, or is there a logical reason an otherwise patriotic American would sell the market short ?
• If there really is a logical reason to sell short, is it the high-risk endeavor that many experts seem to portray?

Bill O’Neil, founder of Investor’s Business Daily. examined the issue of short selling in his book How To Make Money Selling Stocks Short (2004), and concluded that few investors really understand how to buy stocks successfully. Even fewer understand when to sell stocks. Virtually no one, including most professionals, knows how to sell short correctly.

The truth is that if done properly, the risks of short selling are very similar to the risk of long stock purchases. Read on to see just how similar the risks really are.

Background

First, a definition of short selling is warranted. Short selling is essentially the opposite of buying shares of stock (which can also be called buying long). Instead of buying stocks long, the short seller will borrow shares that he or she does not own from a broker and sell them in the hope that the stock price will drop.

If all goes according to plan, the short seller will buy the shares back at a lower price at some point in the future and return them to the broker. The profit is the difference between the initial selling price and eventual repurchase price of the shares. However, if the shares should rise in price after a short sale is executed and the seller has to buy them back at a higher price, the difference in price becomes a loss rather than a profit. (For further reading, check out Short Sales For Market Downturns .)

Why Short Sell?

Prudent short sellers sell stock short if their research indicates that the share price (market capitalization ) is inflated or that a downward correction is due (and necessary) to bring it back into balance. In contrast, when a long stock purchaser buys a stock, he or she believes that the prospects for the company are good and the share price should, in turn, rise.

Oftentimes, the decision to short sell is due to a belief that there are fundamental issues, such as accounting fraud, that are yet unknown to the majority of investors. For this reason, among others, many argue that short sellers are not the un-American villains they are so often accused of being.

According to a 2007 study by Ekkehart Boehmer, Charles M. Jones and Xiaoyan Zhang (Which Shorts Are Informed?, AFA 2007 Chicago Meetings Paper) short sellers possess important information, and their trades are important contributors to more efficient stock prices.

In 2006, Richard Sauer, a former administrator in the Securities and Exchange Commission’s enforcement division, wrote an editorial piece in the New York Times in which he expressed his support for short selling. According to Sauer, the short sellers’ skeptical scrutiny of companies they feel are overpriced has led them to uncover many of the major financial frauds of recent years.

It is important to note that suspected fraud is not the only reason an investor may decide to sell short. He or she may merely believe that the share price has gotten ahead of itself and is in need of a correction. Because the stock markets aim for perfectly efficient information, selling stock short is a vital way for these types of investors to make their opinions heard. (To learn more about the theory of short selling, check out When To Short A Stock .)

Risks of Short Selling

The two primary perceived risks of short selling are that:

1. In the long term, markets trend upward.
2. Short selling can expose investors to potentially unlimited risk .

While the longest term market trend is indeed upward, there are reliable intermediate downward cycles (bear markets ) that occur with a certain regularity. These bear-market declines tend to occur much faster than the run-ups that occur during bull markets. It is not uncommon to see the major stock averages decline 20% or more during these down cycles. During these periods it can actually be more risky to own stocks long than to be short, as most stocks go down during bear markets. (To learn how to navigate a bear market, check out Adapt To A Bear Market .)

What about the potential for unlimited loss? While theoretically true, this perceived risk is just not realistic. The real risk is how far a stock may move in the wrong direction from the point the trade was initiated before an investor has a chance to exit the trade. Under normal market conditions — when stock spreads are low and liquidity is present — the short investor will have the opportunity to exit a short trade for a small loss of 5-7%. Investors can further protect against downside risk by using some sort of stop-loss or risk-management strategy. (Learn how the right strategy can help you avoid disaster in Ten Steps To Building A Winning Trading Plan .)

The real risk here for a short seller is a possible upside gap that he or she will not be able to react to until after a significant loss has been incurred. Long purchasers have this same risk, only in the opposite direction, with downside gaps. Because of the risk of upside gaps, it is crucial that a short seller do his or her homework before short selling any stock. No amount of due diligence research can guarantee an upside gap will not occur against the short seller, but at least it will make him or her aware of all upcoming known events that may cause such an occurrence and can therefore aid in decision making.

Do Historical Patterns Favor the Long Side?

One can argue that a key difference in risk is that the long purchaser has the historical upward trend of the market on his or her side. For the long purchase, if his research is correct, even if he buys at the worst possible time and finds himself initially at a large loss, historical odds say his long purchase may work out over time. While this may be true, it opens up the question of how much time it will take; there are no guarantees that stocks that decline in a bear phase will ever regain their previous bull-market levels.

In regards to time, it is important to note that short sellers do not initiate trades with the intent of long-term sell and hold. The intent of short selling is to hold the short position until the perceived balance returns. We have enough historical data to state without a doubt that the markets are cyclical. If a short seller has done her homework and has indeed identified a grossly overvalued company, even if she turns out to be early in her short sale, she may be proved correct in the next down cycle. Of course, a short seller should never hold a short position that is moving against her beyond a predetermined risk-tolerance level, just as a long purchaser should never hold a losing long position that has moved against him beyond his own risk-tolerance level. (For further reading, check out Survival Tips For A Stormy Market .)

Conclusion

If practiced properly, short selling is no more risky than long stock purchases. More research is likely still needed, but one day researchers may conclude what many already believe: short selling is a much needed, effective method of regulating the markets. If more people were educated on short selling, there would be less fear surrounding it, which in turn could lead to a more balanced market over the long term.