Every Wednesday, we publish our “Investor Toolkit” investing advice series. Whether you’re a new or experienced investor, these weekly updates are designed to give you our specific advice on successful investing. Each Investor Toolkit update gives you a fundamental piece of investing advice and shows you how you can put it into practice right away.

Tip of the week: “Short selling stocks may seem like a potential money-making opportunity, but there are pitfalls that don’t exist when you’re buying stocks.”

Attractive opportunities for short selling stocks come along from time to time, but it’s a difficult way to make money. Short sellers face a number of unique disadvantages that don’t apply to buyers.

When you sell short, you borrow stock from a broker and then sell it. However, you eventually have to buy back the stock on the market to return it to its owner.

If the stock falls in price while you are “short,” you can buy it back at a lower price. You have then made a profit. But if the stock rises in price, you must buy it back at a higher price than you sold it, and you lose money.

There are three more factors that can work against you in short selling.

1. Your potential for loss is limitless: The main risk you face when short selling is that the returns are upside down. That is, when you sell short, your maximum gain is 100% (if the stock you’ve shorted goes to zero). But your potential losses are limitless. That’s the exact opposite of a regular stock purchase, where your gains are theoretically unlimited, and the most you can lose is 100%. You also have to pay for any dividends declared by stocks in which you have a short position.

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2. Current market conditions don’t favour short selling: If you’re interested in selling short, the best time to do it is when the market has been booming and investors are confident and have profits to invest. That’s when you find plenty of stocks trading way above any reasonable estimate of value. But in today’s market conditions many stocks remain attractive, based on any reasonable assessment of their value. So it’s a particularly bad time for short selling.
3. Buying puts can take the place of short selling, but puts require precise timing: Instead of short selling, some investors buy put options. These options offer an investor the opportunity to sell a particular security at a specific price within a specific time frame. Like short sellers, put buyers make money when the investment in question goes down.
   
   When you buy and sell puts, however, timing makes all the difference. If stock prices hold steady or rise, your puts can expire worthless. In addition, part of the value of a put or any option is based on how long it has left before it expires. As a result, puts tend to lose value as time passes, even if the price of the stock holds steady.

You may want to indulge in short selling from time to time, but we advise against doing so as a habit, mainly because of the greater risks of short selling as compared to regular stock purchases. That’s why you should only take part in short selling with money you can afford to lose.

If you’re concerned enough about market turbulence to take action, we think you’re better off converting some of your holdings to cash. This will hurt your portfolio’s potential for gains. But, unlike short selling, it won’t increase your risk.

COMMENTS PLEASE—Share your investment knowledge and opinions with fellow TSINetwork.ca members

Have you had a particularly good result short selling stocks, or a particularly bad one? Or both? Would you recommend the strategy to other investors? Let us know what you think in the comments section below. Click here.