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Contrarians' Day: Getting on the Short Side of Frothy Stocks

Crime, as one of the gangsters in The Asphalt Jungle says, is only a left-handed form of human endeavor. Similarly, short-selling -- or placing a bet that a stock is going to decline -- is a left-handed form of investing. While reviled by many on Wall Street, shorting is no crime, and it has paid quite nicely over the past three years.

In retrospect, March 2000 was a great time to short the market, but trying to time the market, up or down, isn't easy. Nonetheless, a lot of individual investors who have learned rather painfully that stocks don't always go up are mulling short-selling stocks.

Because the market isn't nearly as frothy as it was a few years ago, much of the focus has swirled around the Internet's Big Three: eBay (EBAY - Get Report), Yahoo! (YHOO - Get Report) and Amazon (AMZN - Get Report). Since Oct. 7, eBay and Amazon have roughly doubled and Yahoo! has more than tripled. The latter two sport triple-digit price-to-earnings multiples, and eBay's P/E isn't a hair's breadth away. It's not hard to see why would-be short-sellers are drawn to these phoenixlike shares, hoping they once again crash and burn.

But short-selling carries additional risks for individual investors -- and it can be a costly endeavor. Even if an in-depth analysis into these three stocks leads you to conclude that they are overvalued, the rest of the market might not come around to your way of thinking for a while. As economist John Maynard Keynes said, the markets can remain irrational longer than you can remain solvent. Also, when you go long a stock, the most you can lose is 100% if it goes to zero. Your potential losses on a short sale are limitless.

For today's column, we'll run down the basics on how to short-sell a stock, and whether it's right for average investors.

The Basics

Selling short is a way investors make money on stocks that they believe are going to decline in price in the near future. The important thing to remember: Shorting, while offering a smart way to make bearish bets, carries significant downside risks.

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