Short selling is another way to borrow to make money investing. There are two main situations where you would use this strategy:
- You think that the price of a stock is going to drop. You borrow shares (usually from your brokerage firm), and sell them immediately at the current price. If the share price falls, you buy them back at the lower price, and return the shares you borrowed. This is called covering. You make profit by selling the shares at the higher price, and buying them back at the lower price.
- You think that the price of a stock is going to rise, so you invest your own money in it. At the same time, you want to cover yourself in case you are wrong. You short sell the same stock to protect yourself from losses if your original investment backfires and the price drops. This strategy is known as hedging.
What makes short selling risky?
Short selling is considered a speculative investment. The risks are very clear. You can only guess that the price of the security will fall, so you can lose money if the price rises instead.
- You must have a margin account with your dealer before you can do short selling. Margin levels for short selling are much higher than typical margin borrowing, because of the risk involved with using borrowed shares.
- Short selling of securities in Canada is subject to provincial securities laws and marketplace rules. Make sure you understand all the rules.
Remember: Short selling multiplies your gains and your losses.
You have to be able to live with those larger losses. Also, make sure the investments you are planning to leverage match your investment goals and objectives. If not, you could find yourself living with more investment risk that you are really comfortable with.
Read Borrowing to Invest: Understanding Leverage, to learn more about borrowing to invest.
Content in this section is provided in partnership with the Investor Education Fund, a non-profit organization promoting financial literacy to Canadians. To find out more go to GetSmarterAboutMoney.ca.