FOOL'S SCHOOL DAILY Q&A
All About Shorting
The long and the short of it

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By Selena Maranjian (TMF Selena)
April 23, 2002

Q. What does "shorting a stock" involve?

A. You're probably familiar with this investing mantra: "Buy low, sell high." You might not know it, but if you've spied a stock you're pretty sure will tank, there's an interesting way you might profit from its fall. You'd reverse the old saying -- by selling high and then buying low. This is shorting a stock.

Here's how it works. Let's say that an Internet fan club, GroverCleveland.com (ticker: GROVY), has gone public. Despite much media hoopla, you have little faith in it and expect the stock to drop from its current price of $35 a share. You call your brokerage and say that you want to short 100 shares of GROVY. The brokerage will "borrow" shares from a GroverCleveland.com shareholder's account and proceed to sell them for you, depositing the proceeds ($3,500) in your account. Then, once the share price drops to, say, $20, you'll "cover" your short by buying shares on the market to replace the ones you borrowed. Thus you'll have made a profit of $1,500 ($3,500 minus the $2,000 you spent to replace the borrowed shares).

This technique sounds weird, but it's perfectly acceptable and done often. Shorting can be beneficial because:

  • With shorts in your portfolio, you might profit from both rising and falling stocks. If you see a great and growing company, you can buy shares in it. If you see a stinker, you can profit by betting against it.
  • Shorting can bolster a portfolio. If the market takes a big drop, your shorts should boost your portfolio's performance.

Shorting has its negative side, too, though:

  • If the stock price rises, you lose. With shorts, you can only earn up to 100%, since a stock price can't fall lower than zero. But if your short keeps rising, your downside is theoretically unlimited. Since you can actually lose more than 100% of your money, you need to keep a very close eye on any shorted stocks.
  • Shorting is based on short-term expectations, and Fools generally prefer to focus on the long term.
  • It bucks the overall upward trend of the market.
  • If you short a company, you'll have its management working against you to make the company succeed, perhaps with new financing, partnerships, or products.
  • If the stock you shorted pays dividends, you'll be required to pay the dividend to the shareholder whose shares you borrowed. (Your broker should take care of this.)

Shorting can be effective, but it's only for seasoned investors. Even experienced investors may want to avoid it -- unless they run across a business as unpromising as GroverCleveland.com, that is.

Read up on shorting in our FAQ, our 13 Steps (scroll down for shorting), and in this classic article by Jeff Fischer. For more info, you may enjoy "The Art of Short Selling" in a recent issue of The Motley Fool Select. You can also share shorting ideas with fellow Fools on our Shorting Stocks discussion board.

If you have any thoughts or opinions on this topic, share it with others on our discussion board for Ask the Fool.

This question and answer is adapted from The Motley Fool Money Guide: Answers to Your Questions About Saving, Spending and Investing. For answers to this and 499 other common money questions, check it out -- it's a handy resource.