We’ve recently discussed about what short selling is and how does it work in financial markets. You’ve probably known by now that you can not only gain profit from rising markets, but you can also grow your money from falling markets.
Despite the profitability of short selling, it also entails a high level of risk. It is important to be knowledgeable about trading and be aware about the risks associated with short selling before you go and place a short sale order.
Not intending to discourage you, but the risks associated with short selling are limitless. Here are some of the examples of the risks you have to face if you want to try short selling.
Losses are Limitless, Gains are Limited
There is no limit on how much a trader could lose in a trade, as the market’s price can keep increasing in value as long as the stock or security is doing good. However, the profit a trader can get from short selling is limited, as the stock or security’s price can never fall lower than zero.
You’re going against a powerful market trend
History is a clear proof that stocks are generally in an upward trend. In the long term, most stock prices rise in value. Basically, that means that even the company that showed barely any improvement in the recent years can be driven upward by an inflation.
So, whenever you place a short sale order, you’re basically trying to trade against the direction of the market.
You might be forced to buy back the stock at the most unfortunate moment
In short selling, the trader is basically given the privilege to decide how long he wants to borrow the stock or security before he returns them to the lender. This gives the trader the freedom to carefully evaluate the market and determine the perfect timing to buy back the stocks he borrowed at the lowest price possible.
However, if the lender suddenly feels like he wants to acquire the stocks back, he can basically “call away” the short seller and demand him to return the stocks back immediately. This forces the short seller to buy back the stock at the current market price, even if it means losing money and potential profits.
This event normally happens when the value of the stock continuously rises in value to the point that the lender starts to doubt whether the short seller will be able to repay the borrowed securities should the price surges further.
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