A Short Look at Shorts

The traditional way to make money in the stock market is to "buy low and sell high." But many investors ask us about another way to profit called "shorting," where the trick is to "sell high and buy low."

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 rule to remember is that 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 troubles.

For example, you borrow 100 shares of IBM(IBM - Cramer's Take - Stockpickr) 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.

Before you decide to short a stock, understand these topics.