Short-selling is a necessary component of the market. Without it, stock prices would reflect only optimism -- a dangerous prospect, in extreme quantities. However, I can't really recommend shorting to individual investors, and I don't practice it myself. It's a quick and easy way to lose your shirt.
Lessons in sensible shorts
Investors, pundits, and corporations like to villify the act of short selling, but smart short sellers often uncover danger signals in companies. Enron is one good example. Michael Lewis's new book, The Big Short, also chronicles how some folks saw the signs of the housing bubble, even as too many players were locked in boundless optimism. Those who realized the complete reality disconnect of the bubble shorted it and profited hugely.
Always be wary of those who try to blame shorts for any bearish drag on a company's stock; that pessimism may be rational. In March 2008, a representative of now-defunct Lehman Brothers said: "There are a lot of rumors in the marketplace that are totally unfounded. We are suspicious that the rumors are being promulgated by short-sellers of our stock that have an economic self-interest." We now know those rumors were, in fact, very much founded.
This is a test; this is only a test
Investors who'd like to test out their bearish theories without risking their real money can learn some good lessons in CAPS by using the thumbs-down "underperform" button on stocks.
I've ridden out some interesting rollercoasters from the safety of our online investing community. Years ago, I found myself hundreds of points in the red on Crocs
A rally like last year's can also illustrate how difficult short-selling can be when optimism runs rampant. Abercrombie & Fitch
One of my biggest stinkers is an underperform on Limited
That hasn't stopped me from trying again. We'll see how my very recent underperform call on BP
Proceed with caution
I've had some red-thumb victories in CAPS, including still-struggling Borders Group
And of course, if you're long, a stock can only go to zero. In theory, losses on a short can be infinite. Investor, beware.
What do you think of short selling? Fire away in the comments box below.
Alyce Lomax does not own shares of any of the companies mentioned. The Fool has a disclosure policy.