What Do I Need to Know About Shorting Stocks?

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This column was originally published on TheStreet.com on Oct. 9, 2003. It's being republished as a special bonus for TheStreet.com readers playing the Beat the Street Game. For more information, about the Beat the Street Game, please click here.

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 Quote - Cramer on EBAY - Stock Picks) , Yahoo! (YHOO Quote - Cramer on YHOO - Stock Picks) and Amazon (AMZN Quote - Cramer on AMZN - Stock Picks). Since Oct. 7, 2003, 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 phoenix-like 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 on 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.

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