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What Is Short Selling a Stock?

In today's "Ask the Expert," fund reporter Stephen Schurr gives you the nuts and bolts of betting against a stock by selling it short, a strategy that could be more appealing as the market continues to vault higher.

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.

Much of the focus has swirled around the Internet's Big Three: eBay (EBAY), Yahoo! (YHOO) and Amazon (AMZN). Since Oct. 7, eBay has soared a split-adjusted 141%, Yahoo! has catapulted 377% and Amazon has climbed 252%. All three have lofty price-to-earnings multiples, even based on 2004 earnings estimates: Amazon at 68, Yahoo! at 86 and eBay at 58.

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 of Short-Selling

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.

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 (a hypothetical price to make the calculation easier) 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 Advisor). 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.

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 of trading on margin).

Short-covering: When you close out a short sale, known as short-covering, you repurchase the shares and give them back to your 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 positions, 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.

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 (split-adjusted) high $30s. After solid quarterly results and continued dog-piling into the stock by fund managers, the stock hovers around $61. Even if the stock is richly valued, it may take 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 by Steve Smith.

This article was written by a staff member of TheStreet.

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