A Short Look at Shorts

While wisdom says to 'buy low and sell high,' an alternative idea is to 'sell high and buy low.'
Author:
Publish date:

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) - Get Report

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.

Margin Madness & Short Squeezes

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.

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.

There also are some restrictions on short-selling that may discourage some investors from giving it a go. You can't short-sell 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, or ETFs, however, are not subject to the uptick rule.)

Also a key note 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 standard stock investing, 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, causing some serious damage.

Consider

Google

(GOOG) - Get Report

. After a long streak of solid quarterly results and continued dog-piling into the stock by fund managers, Google shares have climbed to the mid-$400 range, a level where some investors and analysts are starting to think the stock has gotten ahead of itself.

Even if the stock is richly valued, however, it may take months before some catalyst, such as weak earnings guidance, puts 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 by buying call options, which increase in value when a stock goes up.