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The concept of shorting stocks is often misunderstood by retail investors like you and me. Shorting can be demonized by companies, politicians, and commentators when it contributes to bringing a company to its knees -- and sometimes deservedly so.
But shorting stocks can actually reduce risk in your portfolio and open up a path to profits if the market goes down. It's just important to understand what you're doing, so I've outlined a couple of ways to start shorting stocks.
What shorting is all about
When you short a stock, you borrow shares from your broker and sell them to someone else. To close the position, you buy them back, give them to your broker, and count up your profits or losses. It's really no different from buying a stock, except the sale date is before the purchase date. The rest of the logistics can be left up to your broker.
You're not a hedge fund, but you can act like one
Where the word "shorting" gets a lot of its negative connotation is from hedge funds, which profit from stocks going down, often in very public ways. Hedge fund manager David Einhorn gained fame by publicly shorting Lehman Brothers before its collapse. Over the past year or so, he has been public about his dislike for Green Mountain Coffee Roasters (Nasdaq: GMCR ) and St. Joe Co. (NYSE: JOE ) . Einhorn may have a stage to act on, but you too can make similar bets on stocks you think are overvalued.
A simple short strategy is to find a stock that you think is overvalued and short it. Or maybe a company you think will fail altogether. A year ago I highlighted three clean energy stocks I thought might fail -- perfect candidates for shorting. The only distinction from buying a stock is that you think the stock will go down instead of up.
The long and short of it
Another strategy you can use to your advantage is shorting a company while buying a competitor as a paired trade. This strategy would make sense with companies such as Caesars Entertainment (Nasdaq: CZR ) and Melco Crown (Nasdaq: MPEL ) , which are both gaming companies. Caesars has exposure to the U.S. market, a majority of which is in regional gaming, where growth is slowing. Meanwhile, Melco Crown has exposure to Macau, where gaming is booming. Caesars is losing money, and Melco is profitable, so I'd see this as a good long/short candidate.
The long/short strategy is good for a couple of reasons. First, you can make money on both sides of the trade if your strategy is sound. Second, you remove some of the market risk associated with the stock market. If both stocks go down, you make money on Caesars while losing money on Melco Crown. The end result would be a smaller loss or even a profit, versus losing money by only owning stocks.
A word to the wise
Shorting stocks can be helpful but they can also pose some dangers.
Watch out for a short squeeze in stocks that have a high short interest. Short interest can easily be found online in places like Yahoo! Finance Key Statistics, and if you start seeing a short interest over 5% you should be careful. If the stock starts to pop, a big short interest can add fuel to the fire as traders buy the stock to get out of their short trade. So keep short positions small.
Growth stocks are dangerous because you never know when they're going to stop rising. Netflix (Nasdaq: NFLX ) was a popular short trade last year before it came crashing down, but some got into the position too early. Was Netflix overvalued at $200? Probably, but it shot past $300 before it crashed. Exuberance is irrational in the market, so be careful shorting growth stocks.
Foolish bottom line
Shorting can be good for almost any balanced portfolio so long as you do it right. Find companies that are underperformers in their markets, are overvalued, and don't pose a lot of downside risk in the case of a short squeeze or never-ending growth stock are great short candidates.
Another long/short idea is presented in our free report, "The Death of Wal-Mart: The Real Cash Kings Changing the Face of Retail." To find out which two companies you should buy instead of Wal-Mart, click here.