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When Short Selling Is Done Wrong

Betting a security will go down (a.k.a. selling it short) involves significantly more risk scenarios than betting it will go up. Here are the main ones, and how you can guard against them.

Gather round. Kids in the front, take a knee. We're going to talk today about something topical of late that a few of you have been asking about, but some beginners quite understandably do not have a firm grasp of.

Let's talk about short selling stocks (or any security). But not the happy story about doing it right, or the additional liquidity that the practice can add to a market. Let's talk instead about the dark side of this next step in risk taking, which can shock -- both financially and mentally -- those who get involved in it that aren’t fully prepared.

First Things First

Just so everyone is on the same page -- buying stocks that an investor thinks will rise in price is referred to as going long. Hence, the least complex way to bet on a stock that one does not already own to go down is to "short" sell that stock. When "shorting" a stock, an investor must borrow that stock from another investor (but for practical purposes, from the brokerage), and then cover (or buy back) those shares at a later time, hopefully at a lower price, enabling them to pocket the difference.

Read more: 7 High Short Interest Stocks That Could Break Out

Because one must borrow, one must have a margin account with their broker, not an ordinary cash account. Taking this step in itself is taking and accepting a potential for increased risk, and must be understood as such.

On top of the need to borrow in order to participate in the market as a short seller, there are inherent disadvantages that short sellers experience as opposed to what purchasers of stock go through. First, the buyer initiating a long position has in theory a finite amount of money they can lose on any given trade (i.e., if the stock goes to zero), and the potential for unlimited profit. A bearish trader initiating a short position, on the other hand, does so with the knowledge that profit is limited and their potential losses infinite.

In addition, the brokerage will charge interest on the short position much the same as they would with a long position entered into using margin. This interest can mount, and though there is no time limit on how long a short position can be held, the interest charged will reduce an investor's net cost basis from the original point of entry over time, making it more difficult to purchase back the shares at below cost.

Avoiding Trouble

Now that we have covered the basics, we can cover going about selling shares short and staying out of trouble. Professionally, I have had to short stock for any number of reasons over the years -- chief among them was when I had to take the other side of large trades by institutional customers such as mutual or hedge funds. That's something you probably will not have to worry about.

Read more: Bob Lang writes for Real Money on why short selling is necessary

For my own trading, as I do with every single one of my long positions, I create a target price; a pivot point where a stock could stop moving or gain momentum, possibly causing me to act; and a panic point, which is a price where the prudent investor must admit defeat and throw in the towel. Where my shorts differ from my longs arises from the fact that I am far less comfortable with a short that has gone against me, than I am with a long gone wrong -- it’s just something I know about myself. For that reason, and because over time, equity markets usually go higher, I keep my shorts smaller in size than I do my longs, and I am far more likely to jump the gun on a short position -- i.e., exit it before it reaches my target price -- than I would with a long position.

Another personal rule of mine is to not make a habit of carrying short positions over weekends. Two days is a long time -- what could go wrong, you ask? National news, market news, corporate news, political news or headlines made by policy makers all can change pricing on the spot, never mind over days when the markets are not even open for business.

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Lastly, keep in mind that the most dangerous short trade is a crowded short trade. We have all read about the wild swings in the past month for a number of low-priced stocks of companies that had poor fundamental business models, and due to that, high short interest, meaning that the collective bet against these stocks was very large. You can find out what the latest reported short interest is in a stock by going to Yahoo! Finance, searching for the stock, clicking on the "Statistics" tab and looking under “Share Statistics” (as an example, here’s where you can find the short interest in Disney).

Read More: Bob Lang writes for Real Money on the mechanics of short squeezes

That can create what is called a "short squeeze." As a stock price rises, pressure mounts on short sellers to buy back their positions at a loss. Imagine if you will, watching losses mounting quickly while other short sellers are covering their positions. That's pressure.

If it goes too far, the investor either has to add capital to his or her account in order to satisfy the broker's margin requirements, or the brokerage can decide to close out the position at a loss for the investor in what is known as a "margin call."

What I Do...

To guard against getting caught up in a short squeeze, I look at the percentage of any stock's float that is currently held in short positions, which can again be found at Yahoo! Finance, or probably even your broker's website. I become cautious when this percentage approaches 8% and I just WILL NOT short a stock once that figure hits 10%. I mean, who wants to short a stock where 10% of the float is basically a ticking time bomb?

What You Can Do...

1. If you’re short, place an automatic stop order at the level you consider to be an acceptable loss. For me, that's usually around 8%.

2. If you’re able to trade options, buy one call, which is the right to buy a security at a given price (the strike price) within a given time period, per 100 shares you’re short. Choose a strike price at that acceptable loss level and an expiration date that you deem desirable. In other words, know the maximum amount that you are willing to lose, and know your time horizon.

Now, this next part gets even more complex but is useful information once you understand it. A trader could theoretically pay for that call option with the sale of a like number of put options, which are obligations to buy stock with a strike price below your short price (clinching a profit) that pays enough of a premium to cover the cost of the calls. This will likely cap profits at a reduced level, but will also manage the risk.

Keep in mind that purchasing the call options without selling the put options will reduce your net cost basis, which is not good for a short position because the premium paid must be subtracted from the price where the shares were shorted in order to determine your actual profit/loss.

It's pretty complicated, I know, but if you have questions, feel free to go to my author page on Real Money and send me a message from there. Don't worry -- I won't bite. 

Stephen “Sarge” Guilfoyle writes on stocks and the markets each trading day for Real Money, TheStreet’s premium site, including his popular Market Recon column every morning. Guilfoyle is also co-portfolio manager of TheStreet’s Stocks Under $10.