Selling short is a way investors make money on stocks that they believe are going to decline in price in the near future.
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.
If you short a stock whose price rises, things can get really ugly.
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 and take a loss.
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.
If the stock you are shorting rises, investors have to put more money into the account.
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.
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 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 investing in stocks on the long side, 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.
Investors looking to protect their short bets should consider the following:
Set a limit on how much you are willing to lose on a short bet, stick to it and you should consider hedging their bets through options.