When you buy a stock, or take a long position, your maximum downside is your initial investment. So if you buy a share of stock for $10, you can lose a maximum of $10 if it somehow goes to zero.
By contrast, when you sell a stock short, the downside is unlimited. So it’s far more risky to take short positions when compared to taking long positions.
I’ll give you a simple example to demonstrate in case anyone is confused about what it means to sell short. When you sell a stock short, you are borrowing shares in hopes the price will go down.
So let’s use that same $10 share of stock. If I borrow 1 share of stock today from Jack, I can then sell that share to Susan for $10. If the price then goes down to $5 tomorrow, I can buy a share for $5 and return it to Jack. So I sold the stock yesterday for $10, bought it back for $5 today to return it to Jack, and pocketed the $5 difference as my profit (in reality there is also a borrowing fee, essentially interest you are paying on the loan).
But, if the stock instead doubled to $20, I would have lost $10. Or if it tripled, I would lose $20. So the more the stock goes up, the more I stand to lose.
So, due to the risky nature of shorting stocks, and my limited knowledge and experience trading, I have never shorted a stock. (I got pretty close with SnapChat - should have pulled the trigger)
That changed a few weeks ago. Well, I guess you would say it kind of changed, given that I shorted the overall market as opposed to an individual stock. And I did it in a way that I didn’t realize was possible. Specifically, I came across the concept of an inverse ETF. That is, there are inverse exchange-traded funds that seek to provide -100% of the return of the target fund.
So you can buy SPY, which is an ETF that seeks to match the return of the S&P 500. Or you can buy SH, which is an inverse ETF that seeks to provide the inverse return of the S&P 500. (the goal is for SH to go down the same amount that SPY goes up - you can see the 2-year chart of SPY vs SH below)