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

If the stock you are shorting rises, the account is subject to a maintenance margin -- investors have to put more money into the account. The regulations governing margin accounts are a bit more stringent on short sales: For every 20% gain in the stock price, you have to funnel another 30% into the margin account.

While margin requirements vary at different brokerage firms, buying or shorting stocks on margin carries heavy risks for average investors (see this story from a few years back on the basics).

Short-covering: When you close out a short sale, known as short-covering, you repurchase the shares and give them back to you broker. Covering your short position at a loss can get ugly during a short squeeze. A squeeze occurs when a stock that has been shorted by many investors rises. More and more short-sellers must buy shares to cover their short position, putting greater upward pressure on the stock price.

You can short a stock for as long as you want, unless your broker demands you give back the stock that you borrowed, which doesn't happen often. When you return the shares to the broker, you have to pay any dividends the company hands out.

You Can't Always Short What You Want

There are some restrictions on short-selling that may discourage some investors from giving it a go. First off, you can't short-sell over-the-counter stocks or, sometimes, stocks that are trading below $5. Also, the price at which you short a stock must be at the market price or higher -- thanks to the uptick rule, which was instituted to avert continuous short-selling during a market decline as was witnessed in the 1929 crash. (Exchange-traded funds, however, are not subject to the uptick rule.)

Also key for individuals: Most short sales usually must be executed in round lots of 100 shares. In other words, shorting a round lot of eBay will run you about $10,000.

Who Needs Shorts?

Because of the costs and risks associated with short-selling, most individuals have no real need for short-selling in a diversified portfolio.

However, many financial planners suggest that individuals satisfy their urge for betting on the market by making side bets -- with less than 5% of one's investments -- on individual stocks. As long as an investor is aware of the additional pitfalls and realizes the potential for limitless losses, short-selling can make for a reasonable side bet.

The trick, as with investing in stocks on the long side, is picking the right stocks. Unfortunately, even if you do an in-depth fundamental analysis of a company and determine the stock is overvalued, the stock can still climb.

Consider eBay. Back in December, some analysts fretted that the company's shares were looking rich in the low $70s. After solid quarterly results and continued dog-piling into the stock by fund managers, the stock hovers around $100. Even if the stock is richly valued, it may takes months before some catalyst, such as weak earnings guidance, starts the stock on a downward spiral.

Investors looking to protect their short bets should consider two simple measures. First, set a limit on how much you are willing to lose on a short bet, and stick to it. Second, investors should consider hedging their bets through options. To learn about one strategy for hedging a short bet, read this column from Steve Smith.