Is short selling a good hedging strategy during overzealous market conditions?

Short selling can be a good strategy to hedge, but you have almost unlimited downside. If a stock price skyrockets, you may be forced to cover your short by the brokerage before you want to or put up more capital.

A smarter strategy to hedge, that limits your potential downside is to buy puts if you think the market is going down. Your downside is limited to the total amount that you purchased the put for and no more.

Another way to hedge is to SELL calls that are covered because you own the shares the calls refer to. You might do this if you thought your stock was going to go down but you didn't want to sell your shares right now. That way the only downside if the price goes up is you give up your shares at a predetermined price and you miss out on the upside, but your downside is now diminished by the premium you were paid for the option. (You'd still lose money if the shares went down since you still own them, but you got paid the option premium so that helps offset that).

The problem with short would be that even if the stock eventually falls, it might raise a lot in the meantime, and unless you have enough collateral, you may not survive till it happens.

To sell shares short, you first need to borrow them (as naked short is currently prohibited in US, as far as I know). Now, to borrow you need some collateral, which is supposed to be worth more that the asset you are borrowing, and usually substantially more, otherwise the risk for the creditor is too high. Suppose you borrowed 10K worth of shares, and gave 15K collateral (numbers are totally imaginary of course). Suppose the shares rose so that total cost is now 14K. At this moment, you will probably be demanded to either raise more collateral or close the position if you can not, thus generating you a 4K loss. Little use it would be to you if next day it fell to 1K - you already lost your money!

As Keynes once said, Markets can remain irrational longer than you can remain solvent.

See also another answer which enumerates other issues with short selling.

As noted by @MichaelPryor, options may be a safer way to do it. Or a short ETF like PSQ - lists of those are easy to find online.

Below is just a little information on short selling from my small unique book "The small stock trader":

Short selling is an advanced stock trading tool with unique risks and rewards. It is primarily a short-term trading strategy of a technical nature, mostly done by small stock traders, market makers, and hedge funds. Most small stock traders mainly use short selling as a short-term speculation tool when they feel the stock price is a bit overvalued. Most long-term short positions are taken by fundamental-oriented long/short equity hedge funds that have identified some major weaknesses in the company. There a few things you should consider before shorting stocks:

• First of all, you want to short stocks when the market sentiment is negative (in the bull market most stocks go up, and in the bear market most stocks go down);
• You should also look for changes, besides an expected profit taking, that may trigger a stock price decline, such as massive insider selling, a lower-than-expected earnings report, profit warning, a dividend cut, etc.
• Beware of short squeezes and takeover bids (small caps are more vulnerable);
• Check the short interest (ratio) and its trend;
• Be quick (stock prices decline several times faster than they rise);
• Cut the losses short and don’t average down your losing short positions to avoid being caught up in a cross fire of a short squeeze scenario like Volkswagen;
• For longer tern short positions, one of the best candidates to short are the former leaders, big winners, close to the top of the bull market, as these same winners of the last bull market usually fall the hardest in the next bear market. Early cyclical stocks are also good candidates to short in the beginning of bull/bear markets.

Despite all the mystique and blame surrounding short selling, especially during bear markets, I personally think regular short selling, not naked short selling, has a more positive impact on the stock market, as:

• Short selling leads to better price discovery;
• Short selling increases liquidity, which in turn narrows the bid/ask spreads;
• Short selling may also serve as a hedging tool or a pairs trading tool;
• Short selling provides profit opportunities in bear markets;
• Short sellers are a counterforce against upside-biased insiders, stock analysts, investment bankers, stockbrokers, stock investors, and creditors.

Lastly, small stock traders should not expect to make significant profits by short selling, as even most of the great stock traders (Jesse Livermore, Bernard Baruch, Gerald Loeb, Nicolas Darvas, William O’Neil, and Steven Cohen,) have hardly made significant money from their shorts. it is safe to say that odds are stacked against short sellers. Over the last century or so, Western large caps have returned an annual average of between 8 and 10 percent while the returns of small caps have been slightly higher.

I hope the above little information from my small unique book was a little helpful!

Mika (author of "The small stock trader")

I saw that an answer hasn't been accepted for this yet:

Being bearish is a good hedging strategy. But being hedged is a better hedging strategy. The point being that not everything in investments is so binary (up, and down).

A lot of effective hedges can have many more variables than simply "stock go up, stock go down"

As such, there are many ways to be bearish and profit from a decline in market values without subjecting yourself to the unlimited risk of short selling.

Buying puts against your long equity position is one example.

Being long an ETF that is based on short positions is another example.

Point of order: "What goes up must come down" refers to gravity of terrestrial objects below escape velocity and should not be generalized beyond its intent. It's not true that stocks MUST come down just because they have gone up. For example, we would not expecting the price of oil to come down to 1999 levels, right? Prices, including those of stocks, are not necessarily cyclical.

Anyway, short selling isn't necessarily a bad idea. In some sense, it is insurance if you have a lot of assets (like maybe your human capital) that will take a dive when the market goes down. Short selling would have lost a lot of money in your case as the stock market between 2011 (when you wrote the question) and 2014 (when I wrote this answer) performed very well. On average the long side stock market should make money over long periods of time as compensation for risk and the short side should lose money, so it's not a good way to make money if you don't have an informational advantage. Like all insurance, it protects you against certain calamities, but on average it costs you money.

Right, wrong or indifferent I see account gains of nearly 50% so far this year; now being January 23, 2016. That is mostly staying on the short side. I am not adverse to long positions at all; only hop to the other side when the tide turns. I will probably end up castrating myself on the fence at some point.