What are the risks with short selling?

Short selling is a very aggressive and risky investment but can be a good way to hedge a portfolio or take advantage of falling prices. After all there is a limit to how much a share price could fall in theory (zero) but the upward potential is limitless. Being on the wrong side of the market can be expensive if the shares move up in the opposite direction. A short squeeze may also happen if too many short sellers attempt to exit losing trades at the same time, pushing up the price further as they try to exit at any cost. A short squeeze as such happens when just the slightest bit of good news is enough to send the shares of a heavily-shorted company up sharply. Short sellers have to buy stock to close out their short trades and mitigate their losses which further pushes the price up which can force more short sellers to cover and close their trades, escalating the upward move. In fact, in 2008 Volkwagon was for one moment the most highly valued company in the world after Porsche made public that it had acquired 74% of the voting shares of its associated car manufacturer, causing short sellers to panic and cover their shorts.

Having said that, short squeeezes tend to happen mostly with smaller cap shares where the free float is limited and where low daily volumes could move the stock price. It is a good idea to keep an eye on the short interest ratio for particular shares as short squeezed are usually associated with heavily shorted companies.