Ask a Fool: Is Shorting a Stock a Good Idea?

By Matthew Frankel Markets Fool.com

Q: I have a negative opinion of Snap as an investment. Should I short the stock?

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Selling a stock short or "shorting" the stock is certainly a way to bet against a company's success. I generally advise most investors to avoid shorting, but if you do decide to short a stock, here's what you need to know first.

When you short sell a stock, you're borrowing the shares from your brokerage, and selling them on the open market at today's price. The idea is that when the stock goes down, you can buy the shares back later for a lower price, give them back to your broker, and pocket the difference.

As an example, Snap (NYSE: SNAP) trades for about $22 as I write this. If you were to short sell 100 shares of Snap for $2,200, and the stock falls to $15, you can buy those 100 shares back for $1,500, and the $700 difference is your profit. Sounds good, right?

However, the risk with shorting a stock is the unlimited loss potential. If you short a stock and it goes up, there's no limit to how high it can go. At some point, you'll need to buy back the shares you borrowed from your broker. In our previous example, let's say that Snap has a blowout quarter and the price shoots up to $50. You're now on the hook for buying 100 shares for $5,000. If the stock continues to skyrocket to $100, you'll need to come up with $10,000 to close out the trade, which would translate to a loss of $7,800.

The bottom line is that if you do short a stock, you need to have a predetermined exit strategy in mind -- specifically, a point where you admit you were wrong and take a loss if the trade doesn't go your way.

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Matthew Frankel has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.