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

To sell a stock short, you borrow the shares from your broker, then sell the shares and hold the money and wait for the stock to fall. If it does fall, you buy the shares at the lower price and give them back to your broker, who gets a commission and interest for his or her troubles. For example, you borrow 100 shares of eBay at $100 a share (15 cents below its closing price Thursday) from your broker, then sell them for $10,000. Let's say the stock drops 20% to $80 a share; you buy the shares back for $8,000, then return them to your broker and pocket your $2,000 profit -- minus your broker's commission, which is the same as what you would pay on a stock purchase, and interest.

Now, let's examine the other side. If you short a stock whose price rises, things can get hairy. You can wait to see if the stock will decline, or you buy the stock back at a higher price than you sold them and give them back to your broker (along with the other fees), and take the loss.

Those are the basics. Now let's go over the specifics regarding short sales and execution rules (thanks on the finer points to Steve Smith, TheStreet.com's options columnist who also writes for The Short Report). Before you decide to short a stock, understand these topics.

Margin account: When you designate an order as a short sale, you are borrowing the shares from your broker. Your broker sets up a margin account -- it's a credit that has to be repaid at some time, depending on the discretion of your brokerage firm. An initial investment of $2,000 is required to set up a margin account. With margin accounts, investors are required to deposit at least 50% of the stock price in the account.