Q: How does short-selling work, and is it a good investment strategy if I think a stock has gotten too expensive?
The basic mechanism of short-selling is rather easy to understand. When you hit the "sell short" button in your brokerage account, you are effectively borrowing shares of the stock from your broker and selling them on the open market.
The idea is that if the stock's price drops, you can then buy it back for less than you owe the broker and pocket the difference.
As a simplified example, let's say Company XYZ stock is trading for $100 and I short 100 shares, so I borrow the shares and receive $10,000 from the sale. If a couple of weeks later, the stock is trading for $90 per share, I can repurchase the stock for $9,000, return the 100 shares to my broker, and keep the $1,000 difference as profit.
While the concept is simple, investors need to understand that short-selling can be a risky strategy. For one thing, it's impossible to time the market. Stocks don't behave rationally, nor does a stock being "expensive" prevent it from becoming even more so. Plus, the stock market as a whole has a natural upward bias over the long run (that's why people invest in it).
Finally, short-selling comes with the potential for unlimited losses, since there's no upper limit to how high a stock's price can climb. If a short position starts moving in the wrong direction, your losses can get magnified quickly.
So while short-selling certainly has its place in a healthy and efficient stock market, most investors would be better off avoiding the practice.
The Motley Fool has a disclosure policy.