What is short selling (and should you do it?)

ASX short selling is a common practice for large investors, but should you do it?

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The ASX has been awash in recent weeks with reports covering short selling, otherwise known as 'shorting' or 'going short'. Most short-selling is done by institutional investors or hedge funds, but retail investors can also engage in short-selling if they so wish, either through a broker or an exchange traded fund like BetaShares Australian Equities Strong Bear Hedge Fund (ASX: BBOZ).

So the question for shorting is not if you can, it's if you should.

What is short selling?

Even if you haven't heard of shorting, if you have ever bought a share as an investment, you have already 'gone long'. Going long is another way of saying you're betting that a company's share price will rise (hence why you probably bought the share) but going short is the opposite. Short sellers are investors actively hoping that the share price of a company will go down.

It is done by an investor 'borrowing' shares from another investor (usually via a broker) with a promise to hand them back at a certain point. Once the shares have been borrowed, they are sold, and only bought back when the time comes to hand them back to the original owner. So a short-seller is hoping they can 'sell high and buy low' i.e. buy the shares back at a lower price they were sold for and pocket the difference.

Should you short sell?

The first thing to say is that although shorting can he highly lucrative, it is also very risky. Your potential losses are technically infinite, as a company's share price upside is theoretically unlimited (whereas the lowest it can go is zero if you are long). Another thing to note is although a company may be overvalued, there is no guarantee that it will return to its intrinsic value within your shorting timeframe. You might have to cover your short position a month before the share price plunges (and that won't feel nice at all).

Foolish takeaway

In my opinion, short selling is an investing strategy that long-term retail investors should stay away from. Although you might have made a lot of money shorting AMP Limited (ASX: AMP) or Bellamy's Australia Ltd (ASX: BAL) over the last 18 months, I think going long is just a better strategy and focuses on the best that the ASX can offer, rather than the worst.

Motley Fool contributor Sebastian Bowen has no position in any of the stocks mentioned. The Motley Fool Australia has recommended Bellamy's Australia. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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