Before Shorting a Stock, Here Are 4 Things You Must Know

At the Fool, we generally look at the markets from a buy-and-hold perspective. However, we recognize that there may beinstances where it's tempting to sell a stock short. While there is certainly potential for big profits, shorting is a complex art and it's important to know what you're getting into before doing so. With that in mind, we asked four of our contributing writers what investors should know before shorting a stock. Here's what they had to say:

Jason Hall: If you're going to short a stock, you better have a solid reason why you expect the stock to fall.

Are you counting on short-term downward movement for some reason, such as the stock trading above its historical valuations? Are you shorting because you see a fundamental flaw in the business? Did you hear about it from the "stock trading expert" over the water cooler at work?

The bottom line is this: As Joe describes in his contribution, your gains are limited to how much a stock can fall, while your losses are only limited by how much it can go up before you close your short position. This means you're counting on a lot of things working in your favor, and nothing unexpected happening that makes the stock price go up. This can include industry-specific and macroeconomic things that have nothing to do with the business, and that you can't predict.

If you don't know why you're shorting the stock, or even if you do but you turn out to be wrong, you can lose a lot of money in a short amount of time from those unpredictable things you may never see coming. Short selling can be a valid and practical strategy, especially if you have particular industry knowledge or experience that helps you identify overpriced stocks, but if you're a novice or don't have significant knowledge about the company you're shorting, and especially if you don't really know why you're shorting it,it's probably a strategy to avoid.

Matt Frankel: First of all, I'm not really a fan of short selling -- it's just not a major part of my investment strategy. However, in the past I have occasionally sold stocks short when opportunities came up. One major lesson I learned is the importance of having an exit plan.

As Jason said, before making a trade, it's important to know why you're shorting the stock in the first place. Once you've established that, you need to come up with two pieces of information -- how much you hope to profit from the short sale, and how much you're willing to lose if the trade goes against you. Without these in mind, you could end up robbing yourself of profits by getting out too quickly or worse, hanging on to a losing trade for way too long.

For instance, if a certain stock trades for $100 per share and you feel its P/E multiple of 21 is too expensive because the sector's average is 18, that could potentially be a good reason to sell a stock short. You determine that the stock should be valued at about $86, so you set your sell point at $90 to be a little conservative. And, you decide that if you're wrong and the price increases to $110, you're out no matter what. This is an example of a well thought-out exit strategy.

Personally, I learned this the hard way several years ago when I thought was overvalued at $120 per share and decided to initiate a short position without an end game in mind. Well, over the next few months, shares went up and up, and I eventually cut my losses at a share price of more than $160 a loss of $40 per share.

A responsible exit strategy could have saved me a lot of money, so make sure you set clear boundaries in both directions if you decide to play the short-selling game. As Joe pointed out, losses can quickly accumulate if a short sale doesn't go your way, so discipline is extremely important.

Sean Williams: My Foolish colleagues have hit on a number of key points about short-selling, but one that you absolutely mustn't forget is that short-selling involves the need for a margin account, and margins involve you paying interest.

Because you never actually own the stock in question that you're betting against (your brokerage merely credits you proceeds from the sale of stock) you will need to open a margin account in order to short-sell a stock. Sometimes margin accounts can come with higher minimum equity maintenance rules than a cash account, so it's something you'll want to pay attention to.

But the biggest thing to know is that when you're borrowing money to bet against a stock you'll be charged interest by your brokerage firm. Although lending rates will vary based on the brokerage, how active a trader you are, and how much money you have invested with your brokerage firm, today's margin rates typically range between 7% and 10%. This means that not only are your gains capped at 100%, but you'll also owe regular interest payments to your brokerage. These fees can seriously eat into your profit potential, and they're just another reason why short-selling is considered such a risky activity.

Joe Tenebruso: One of the great things about investing in stocks is the concept known as asymmetric risk. In essence, what this means is that while a stock can lose at most 100% of its value, it could also rise in value many, many times over. In fact, an outstanding business such as can grow more than a 1,000% over time.

In this way, one big winner can make up for a lot of losers in a diversified stock portfolio. When it comes to shorting stocks, however, this asymmetric risk profile is flipped on its head. That's because if you short a stock, the maximum gain you can hope to achieve is 100%, which typically will only occur if the business goes bankrupt and its shares are deemed worthless. But your losses can theoretically be unlimited.

In this way, just one short position that moves sharply against you can wipeout gains on many of your other positions. This is a major risk inherent in shorting stocks, and a good reason why the practice is often best left to more experienced investors. Even then, great care must be taken to size short positions according to their heightened risk profile.

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Jason Hall owns shares of Joe Tenebruso has no position in any stocks mentioned. Matthew Frankel has no position in any stocks mentioned. Sean Williams has no position in any stocks mentioned. The Motley Fool recommends The Motley Fool owns shares of Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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