You Have Two Choices – Long or Short:
The more well-known, conventional strategy for stock trading is “going long” – wherein the trader buys shares with the expectation that the price will increase over time. By contrast, taking a “short position” is a method utilized by traders to take advantage of a stock’s falling price. A short seller essentially borrows (sells) the shares first (thus receiving the current value) and attempts to buy them back at a cheaper price, making a profit from the difference. Long positions are considered “bullish” and short positions are “bearish”.
While short-selling has its advantages when it comes to overvalued companies, there is one major drawback to it. In theory, losses can be infinite. With your classic long position, an investor can only lose the value of their initial investment at most. That’s simply not the case with short positions – there’s no limit to how high a particular stock price can go, resulting in unlimited risk. Example #1: Bob takes a long position on stock XYZ worth $1,000 and the stock goes bankrupt – he loses $1,000. Example #2: Bob takes a short position on stock XYZ worth $1,000. Overnight, the stock price triples – he now owes $2,000 on top of his initial $1,000 borrow. Not to mention the stock price could potentially continue its upward trend, resulting in even greater losses. Consequently, shorting stocks can be rather dangerous if the risks aren’t completely understood and protected against.