Short selling involves selling securities an investor doesn’t already own. A short sale is performed in the belief that the price of the security being sold will go down. The seller can then cover the sale by purchasing the security at a lower price, making a profit based on how far the price has fallen. Short sellers face specific regulations in the markets.

Hedge funds buy good stocks and sell bad stocks “short” in hopes of making money regardless of the market’s direction. If the market goes up, the good stocks should rise more than the weak ones, so the gains on the good stocks should exceed losses on the short sales. If the market falls, the bad stocks should fall more than the good, so gains on the short sales should exceed losses. But profitable short selling requires superhuman timing, and the inevitable mistakes can be super expensive.

In 1999 and 2000, a number of hedge funds collapsed because they shorted Internet stocks that went on to soar. The fund managers were “early rather than wrong,” as the saying goes, but they still lost huge sums. After all, short selling turns the traditional market odds upside down. When you buy, your profit potential is unlimited and the most you can lose is 100%. When you sell short, the most you can make is 100%, but your potential for loss is unlimited.

How Successful Investors Get RICH Learn everything you need to know in 'The Canadian Guide on How to Invest in Stocks Successfully' for FREE from The Successful Investor. How to Invest In Stocks Guide: Find 10 factors that make your investments safer and stronger.  I consent to receiving information from The Successful Investor via email. I understand I can unsubscribe from these updates at any time.

Last year, the global credit bubble caused extreme market volatility. This wreaked havoc on the hedge-fund claim that buying good stocks and selling bad stocks “short” could deliver positive results in any market. As a result, a number of hedge funds disappeared.

Hedge funds, long associated in the public’s mind with reclusive offshore millionaires, are still a prestige item for some investors. In addition, they’re hugely profitable for the sponsors because of incentive fees — investors pay extra if the fund performs well. Brokers are also happy to earn commissions by selling the funds. Hedge funds trade heavily, and they usually trade through brokerage firms that sell them to investors.

It’s a common investment situation. The hedge funds make money; the broker makes money; sometimes even the client makes money. Of course, some investors lose heavily because of the fees and risks. Our advice: stay out.