Dear Dagen: Can I Short Stocks I Already Own?

Yes, it's called shorting against the box, but the IRS has cracked down on this practice.
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Can I short a stock that I own? I know it sounds a little nutty, but I don't want to disturb the long-term capital gain status of an investment. -- Ben Priest

Ben,

This hedging strategy is as old as some of the investment ideas you'll get from your father's stock broker. What you've described is called shorting against the box.

In this trading technique, you lock in gains by shorting the exact number of shares of the stock you own. It used to be a way of locking in a gain without triggering taxes. But abuses led the

Internal Revenue Service

to crack down on the practice.

Short-selling involves borrowing securities from a broker and then selling them into the market. The idea is to buy the stock back at a later date and return it to the broker. If the stock goes down, your short position makes money since you can buy the stock back at a cheaper price. If it goes up, you lose money.

Let's say you have 5,000 shares of

Coca-Cola

(KO) - Get Report

that your dear grandmother left you back when

Gerald Ford

was president. You don't want to sell the stock and trigger a tax event, but you do want to harness your gains. In this strategy, you would need to borrow 5,000 shares of Coke stock from your broker to sell short. You wind up with 5,000 shares long and the same number short.

For every dollar that the stock rises, you make a dollar on your long position and lose a dollar on your short, which neutralizes your profits and losses. If the stock falls, your short position will make up for the losses on your long position.

When you are ready to unwind this trade, you won't have to go back into the market to buy back the 5,000 shares that you have shorted, which is the case in a typical short position. Instead, you will merely deliver your 5,000 shares to your broker to replace the 5,000 that you originally borrowed. Then, the trade is complete.

Before the IRS changed the rules, this strategy allowed you to take your gain in the stock, just as if you sold your long position, but it was not treated as a taxable event until later on when you unloaded your long position.

Now, however, for a simple short-against-the-box transaction, the IRS requires you to pay capital gains taxes as if you had sold your long position outright. A broker still may let you enter into this trade, but there are a few onerous rules you will have to adhere to in order to avoid triggering taxes in the current tax year, says Steve Baxley, director of tax and financial planning at

Bessemer Trust

.

Nowadays, investors favor a strategy called a "collar" for protecting your gains in a stock. This involves buying an out-of-the-money put and selling an out-of-the-money call against a long position. (For more on collars, see an

Options Forum column from last year.)

In Defense of Shorting

Any criticism of short-selling will certainly raise the ire of some investors. Last week I

cautioned investors about the perils of naked shorting (when you don't own the underlying stock). In my mind, there is limited upside potential and a vast downside.

"Your article spreads fear about short-selling," writes

Andy Perahia

. "Since it is clearly an excellent source of stock market gains, you are incredibly misguided in your stance."

Perahia continues. "If a short sale goes the wrong way, you cover. Yet you imply that the risk is infinite. Yeah, if you short and go on vacation. Otherwise, short-selling is a powerful source of profits for many of us. Who do you think you are protecting by cautioning your readers?"

I do think caution is necessary for anyone who doesn't fully understand the intricacies of any investment strategy.

Even a technique like shorting against the box can have its downside. You will lose out on any hefty price gains if the stock climbs. Less-sophisticated investors may not realize this.

Send you questions and comments, along with your full name, to

deardagen@thestreet.com.

Dear Dagen aims to provide general fund information. Under no circumstances does the information in this column represent a recommendation to buy or sell funds or other securities.