Shorting Tech Stocks

Once investors spend some time in the market, they want to try their hands at more advanced strategies. Usually, the strategy they want to learn is how to sell short.

Being long a technology stock can be risky enough; shorting a technology stock can be downright treacherous and is not for the faint of heart.

If you are unfamiliar with "shorting," here's a brief primer on the basics. (I will be employing shorting tactics from time to time in my newsletter, TheStreet.com Technology Report.) Most investors are familiar with "going long" on a stock, where you buy shares in a company, wait for them to rise and then sell. Of course, going long doesn't always work this way. Your shares may go down, and you sell for a loss.

Shorting is the long theory in reverse. Instead of expecting a stock price to rise, investors who short expect it to decline. Unfortunately, shorting a stock is a bit more complicated than going long. To short a stock, you must borrow the shares from your brokerage firm. A short sale on the NYSE requires an execution on an uptick in price. A short sale on the Nasdaq requires a higher bid above the last trade. In both cases, sell orders of long positions take precedence before short sales are executed.

Keep in mind that when shorting a stock, profits occur when the price of the stock goes lower, and only when you "buy to cover" at a lower price are profits booked. The loss possibility can be huge, as the upside for the stock is unlimited. A loss is booked when you "buy to cover" at a price above the price of the short sale.

Let's consider a simple example. You short 100 shares of XYZ company at $50 a share. If XYZ drops to $45 a share, you will have made $500. If shares in XYZ rise to $55, and you buy to cover your short, you will have lost $500 on the trade. One big warning with shorting: You can lose your shirt. If XYZ were to rise to $300 a share, you're out $125,000. That's quite a difference from going long. If you were long your $5,000 investment, that's the most you can lose, even if XYZ went to zero.

One factor that influences loss potential is the "short interest" in a stock. As more shares of a stock are shorted, the short interest increases, which could result in significant losses if a powerful "short squeeze" occurs, in which short-sellers are forced to cover. With a short in a technology stock, unexpected good news for the company or a brokerage upgrade can be the catalyst for a "short squeeze."

There are ways to attempt to minimize the risk of a short position. Whenever I recommend a short, I will also recommend a buy stop, which is the price at which to cover the short should the market price reach that level.

For more sophisticated investors, those who qualify to trade put and call options, there are two strategies to consider: An investor can short a stock and buy a call that can be exercised to cover the short at the strike price. An investor can short a stock by purchasing a put option, which gives the owner of the put the right to sell the stock at its strike price. Options have expiration dates so that the time horizon of the protection is limited unless the investor rolls the strategy to a longer-dated option. I will not be discussing options strategies in TheStreet.com Technology Report.

Options are not suitable for every investor. Please contact your registered representative or the Senior Registered Options Principal at your brokerage firm for the current Options Disclosure Document. (For more information concerning options, you can go directly to the site www.cboe.com.)

Given the risks involved in short stock strategies, I will limit the number of short recommendations in TheStreet.com Technology Report model portfolio to five to seven positions. Candidates for shorting will be based on my screening methods where the stock is at least 20% overvalued, and have a negative weekly chart profile. Each recommendation will also cite a specific negative fundamental reason for taking a short stance now. All recommendations will have a time horizon of five days or longer, and will have a price at which to cover at a profit or on a stop loss.