Shorting, or short selling – the process of borrowing stock to sell and then buy back at a lower price – gives day traders a way to make money when prices are falling. That means double the potential number of trades available, a huge benefit. There are other advantages to being able to go short.

Hedging is one such major advantage. Hedging is the practice of diversifying positions such that should the market move significantly in one direction or another, the trader is covered either way. For example, if a trader has bought a lot of stock in the technology company QCOM, they might go short of a different company, perhaps RIMM. In this way if the market rises, the QCOM position will make a profit covering any loss in RIMM, and vice versa. Hedging can be performed by diversifying between market sectors as well as direction.

There are however, some downsides to short selling stock. The first issue is that not all stocks can be sold short. To go short, the trader must borrow stock from their broker, which implies that the broker must have some of that stock to lend. Clearly, with thousands of different companies being traded on numerous different exchanges, no broker can hold all available stocks. Instead they hold just the most popular. Each broker carries a list of stocks they hold and which are therefore shortable.

Even if a stock is on this list, there is no guarantee it will be available when a trader wants to short sell it. If many traders wish to go short at the same time, there is a good chance the broker will simply run out. So shorting is not something a trader can assume that they can always do.

The other problem with short selling is one of increased risk. If we consider the traditional buying and selling of shares, the maximum risk the trader is exposed to is the price of the share multiplied by the quantity they have purchased. If a trader buys 100 shares of DELL at $12 each, the most they can lose is 100 x $12 = $1200. For that to happen, the stock price needs to drop to zero. It cannot go below that, so that’s the maximum risk. On the flip side, there is no maximum to the profit that could be made; the higher the stock price goes the more money the trader makes.

When going short however, there is no maximum risk, but there is a maximum profit. If we take the same example, and assume a trader short-sold 100 shares of DELL at $12 each, they now need to repurchase those shares at some point in the future to cover their position and pay back their broker. Therefore they want the price to drop. The most the price can drop is to zero, a drop of $12 giving a profit of $1200. But the price can rise indefinitely, and the higher it goes, the more money the trader loses.

In reality, the broker will usually liquidate the traders position at the point where it becomes clear that they do not have sufficient funds to cover it. So the trader cannot lose an infinite amount of cash. Even so, it is well worth bearing in mind that when shorting, the ratio of maximum risk versus maximum profit potential is reversed.

Despite these two “gotchas”, short selling is still an essential weapon in the traders armoury. Without it, there would be some days when there are simply no profitable trades to be made. Having the ability to profit from rising and falling markets means traders can profit every day the markets are open.

Harvey Walsh is a full time day trader, and part time trading coach. His highly acclaimed day trading course teaches anyone to profitably day trade US stocks, even with no prior experience. Visit http://www.daytradingfreedom.com to find out more.

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