Selling Short

There are many ways to invest in the stock market, but the most unusual is probably by selling short. Selling short is basically accomplished by selling stocks you never actually owned and then hoping the stock's price goes down. If this method of investing sounds bizarre, that's because it is! However, it is not uncommon whatsoever.

Let's say an investor determines through whatever means, whether it's his broker's opinion or his study of the corporation or the industry or the market in general, that a stock is selling at a price that is very likely to go down. So the investor sells a specific amount of the stock to a buyer at the current market price (hence the term, "selling short"). The investor's broker then "borrows" (notice we didn't say buys) that amount of shares of the company, which go to the aforementioned buyer. What does the investor get? He gets the purchase price of the stock at current market value.

But wait a minute, how can you sell something you don't own? You can't. Here's where the profit or loss comes in--the investor then has to buy the shares he sold and return them to the "borrower." Remember, the investor is counting on the stock price to fall so he can buy the shares at a lower price than he sold them for. So the investor uses the buyer's purchase funds to buy the cheaper replacement stock for the borrower--and then pockets the difference.

The risks involved in selling short. This complex method of investing carries many risks as well as the potential for abuse. As a matter of fact, in the fall of 2008, due to abuses, prohibitions on selling short were instituted as a temporary measure by both the U.S. SEC and also European market regulators. What are the risks? First and foremost, it is difficult enough to invest in stocks by buying and holding them for the long-term. But predicting a stock's price will fall and then predicting precisely when it will fall is more of a guessing game, even for financial professionals. The stock's price may remain approximately the same or, in a worst-case scenario, go up. If the stock's price goes up, an investor has to pay more for the shares he borrowed and will be out the commissions he must pay for to his broker for the original short sale and this purchase. Can you say "ouch?"

Maybe you're thinking you could just sit tight until the stock's price goes down. After all, it's bound to happen at some point. You could do that, but there are financial repercussions you should be aware of. When you borrow stock from the owner, until you replace his or her shares, you're required to pay him or her the dividends paid on the stock. And remember, you don't own the stock; the person to whom you short-sold does. You can see that paying dividends can get costly.

Even if you don't have to pay dividends, there's a result of sitting tight and waiting for the stock to go down that can be even worse than paying dividends. As a short-seller, you're legally required to keep a balance in your brokerage account that's large enough to buy the stock you sold-short at the price it's currently selling for on the market. If the stock's price keeps going up, you may be forced to buy at a higher price and suffer a loss because you can't afford to add the required cash to your account.

You can see there is a great profit potential by investing through short-selling, but it's very difficult to do so and the risk of financial loss or ruin is great. If you're at an age or stage where such a loss would wreck havoc with your goals, or your personal risk tolerance doesn't do well with stress, you would be wise to put your investment dollars elsewhere. Whatever the results, this type of investment is practically guaranteed to be a nail-biter at least at some point during the transactions.