A Brief Primer on the Fine Art of Selling Short

Most stock investors hope to make a profit by the classic route of “buying low and selling high.” But the short seller follows the opposite tack, selling a stock first and then betting its price will drop before he buys it back. Here’s how short selling works: Mr. Smith borrows 100 shares of XYZ Co. from his broker. Brokers have inventories of shares because they hold stocks for many clients, who give the brokers permission lend those shares to short sellers. Smith promptly sells his XYZ stock in the open market, say for $50 a share, and collects $5,000 (less the broker’s commission on the trade). But Smith can’t run out and spend the money. The proceeds are kept in Smith’s account as collateral for the borrowed shares. When Smith opened his short-selling account, he also had to provide his broker with 50% of the value of the shares--$2,500 in this case--to protect the broker against any losses should the broker have to liquidate Smith’s account. So now there’s $7,500 in Smith’s account earning interest. If Smith’s bet works and XYZ’s stock declines to, say, $40 a share, Smith “covers” his position by buying 100 shares of the stock (total price: $4,000) and returning the shares to his broker. The broker then returns Smith his $1,000 profit (less trading commissions) and his $2,500 deposit.

But good news for everybody else, of course, is bad news for the short seller. What if XYZ’s stock zooms to $60 a share instead? Smith has two choices. He buys back the stock, covers his position anyway and simply absorbs a loss. Or, he keeps waiting for the price to eventually fall--but faces an even bigger loss if the stock keeps climbing.

Losses Can Be Minimized

That’s the risk in short selling. A stock you buy can only drop 100%. But a shorted stock theoretically has no limit in how high it can climb in price, making the short seller’s potential loss open-ended.

Early this year, for instance, footwear maker L.A. Gear was heavily sold short when its stock was trading around $25 a share on the assumption its robust sales forecasts would not develop. But they did, and L.A. Gear recently hit a 52-week high of $77 a share.

But Smith can minimize any potential losses by directing his broker beforehand to cover the short sale at a certain price.

Some sophisticated investors also sell short as a strategy to hedge against any losses they might suffer from investing in stocks they hope will go up in price.

For example, suppose XYZ is selling for $50 a share. Investor Smith could buy the stock at that price and at the same time short it. If XYZ’s price soars, Smith covers the short position and, hopefully, more than offsets that loss by selling his other shares after they have continued to climb, thus turning an overall profit.

And if the stock plummets? Smith does the reverse.

Either way the price goes, Smith has hedged his bets. Like most investment decisions, whether he makes a sizable profit by hedging depends on his timing.