Bill Cara is reading my mind. Just yesterday, for some reason that I can’t remember, I was thinking a lot about short selling. Bill has written a nice piece today in which he asks ‘what’s wrong with short selling?‘ The comments I often hear about shorting, often by some talking head on TV, drive me nuts.

Perhaps the most frequent comment about short selling is that it’s too risky because theoretically your losses can be infinite. Well the key word there is ‘theoretically’. Stocks don’t go to infinity over night. It takes a long time to rack up percentage gains in the thousands of percents (and higher). In the real world your broker will take you out of the trade long before your loss becomes infinite, just like what will happen if you’re in a losing long position on margin. But for traders with any kind of discipline and/or sense going short is no more risky than going long. Trading/investing is all about managing risk as best you can. One of the simplest ways is to set a stop loss at some set, and acceptable, loss amount. Sure stocks could gap up against you but they can also gap down against you when you’re long.

The other thing that I hear, and this is usually from the clowns on message boards is that shorting is un-American. Those people will say things like ‘how can you bet against company X’, or ’so many people’s retirement accounts are tied to company Y’, etc. I respond to those types of comments with take a look at what happened with Enron, MCI, and a host of other companies that short sellers were screaming and hollering about long before the ugly truth was made public. Short sellers are often the first ones to raise warning flags about accounting shenanigans and other shady business at companies. Also it’s important to note that shorts often cause stocks to have sharp rallies due to short squeezes and they tend to provide support for stocks when they finally do drop sharply.

An article at the Motley Fool points out a couple of reasons why shorting is not un-American:

But these smart short-sellers actually provide a public service that is distinctly not unAmerican, at least if you consider market capitalism at all American. For example, shorts know how to sniff out garbage accounting and other shenanigans. This serves average investors in a number of ways. First, our economy is stronger if available capital is deployed in the most productive ways. Crappy companies waste capital, so cutting off their supply as soon as possible means there’s more available for the good companies that create wealth and jobs.

Second, shorts provide liquidity at both ends of the spectrum. They are sellers when others are buying and, eventually, buyers when others are selling. These dynamics can sometimes promote bubbles, as shorts are forced to “cover” their position in a stock like K-tel (Nasdaq: KTEL) that has a small float. More often, though, this liquidity allows buyers to pay less than they otherwise would have and to sell for higher prices than would be possible if shorts didn’t have to buy back the shares they had borrowed.

Besides shorting companies that have questionable business practices, for traders it often makes sense to short just because of the nature of market movement. As we all know the market doesn’t always go up. In fact it usually goes sideways or is range-bound. I think I read somewhere that the market is range-bound 70% of the time and the other 30% is split between going either up or down. Regardless of the exact percentages, to not play the short side would be leaving a lot of opportunities, and money, on the table.

When I trade, long or short, I usually have no idea about the company behind the stock. If my stock scans catch a stock that looks like it’s about to undergo a sizeable move its my job to try to profit from that move, regardless of the direction. I’m just trying to make a buck - you can’t get much more American (capitalist) than that. :-)