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How Short-Selling Can Save Your Portfolio

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The oil spill in the Gulf. Continuing problems throughout Europe. Correction in the stock market. Most shareholders hate events like this. But if you sell stocks short, you could be profiting from them. Is that a bad thing?

Few topics raise as heated a debate as short-selling. Some see it as an evil practice that threatens to destabilize companies or even entire governments. During the financial crisis in 2008, both Citigroup (NYSE: C  ) and Morgan Stanley (NYSE: MS  ) blamed much of their woes on short-sellers. Both Lehman Brothers and Bear Stearns were plagued by short-sellers before their respective demises. And giving short exposure to companies like Goldman Sachs (NYSE: GS  ) via credit default swaps was largely responsible for the downfall of AIG (NYSE: AIG  ) .

But many defend short-selling as an integral part of a functioning market system. It gives investors an incentive to spot bad businesses. Arguably, it makes surviving companies stronger by getting rid of inefficient competitors. Moreover, it can help stop unsustainable bubbles in fad stocks, from holey-shoe maker Crocs in late 2007 and early 2008 to PotashCorp and Mosaic, which rose to amazing heights before coming crashing down. Without short-selling, some argue, one-sided markets might never see the excesses that eventually bring weak companies back to earth.

Is short-selling for you?
As an investing strategy, short-selling isn't as familiar to many investors as buying stocks or mutual funds. That's why we've put together a series of articles looking at various ways to bet against the financial markets and individual stocks. By showing you the potential rewards as well as the risks, we hope you'll get the information you need to decide whether short strategies belong in your portfolio.

Here's our Foolish guide to the many things you need to consider when deciding whether to sell stocks short:

No matter whether short-selling makes your skin crawl or brings on dreams of avarice, take a look at the arguments for and against. Knowing more about short-selling is the best way to figure out whether using short strategies could save your portfolio.

Fool contributor Dan Caplinger is a bit on the short side, but he's not sensitive about it. He doesn't own shares of the companies mentioned in this article. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy won't leave you short.

Read/Post Comments (9) | Recommend This Article (26)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 04, 2010, at 2:09 PM, guiron wrote:

    Cash-covered shorting requires a lot of research and carefully placed stops, so, yes, shorts do tend to be better informed as market participants, but it does speak to the fact that it's something of a treacherous position with unlimited downside. I prefer to use vertical option spreads to go short, so as to limit my risk as well as my cost basis.

  • Report this Comment On June 04, 2010, at 5:16 PM, greenwave3 wrote:

    Agreed. Options are the way to go short (buy put). Shorting has unlimited downside, which should be a huge red flag for any risk-minded investor.

  • Report this Comment On June 04, 2010, at 6:35 PM, ChrisBern wrote:

    Agree with above 2 comments--the easiest, safest way to short something is to buy puts. The commissions on them are a little high, as much as 2-3% of the amount of the puts roundtrip, but it's worth it to achieve short exposure when you feel (a) the market or (b) a particular stock is overheated. I can say that these types of positions have allowed me to break even in the past 2 months, which is saying something since the market's dropped 10-15% in the same time period.

    Further, it doesn't have to be large investments of money. Most of the puts I buy are just $1000 or $2000. Again the trading costs, as a percentage, are higher with lower amounts such as these, but these little amounts can quickly double (or get cut in half) because of the leverage they have. If it's a long-term play, I like to buy Jan 2012 puts that are a little bit out of the money (if the stock is trading for 15, maybe I'll buy puts with a strike price around 10-12).

    Like anything, you have to study how to do these things correctly before employing these strategies, but TMF is a great place for that (the articles linked above look like a great place to start). Frankly if I didn't have short positions down right now, I'd be staying awake at night out of nervousness that I'd wake up the next morning every day with a lower portfolio.

    Last thought, keep in mind that puts will eventually go to $0 as they approach maturity (e.g. January 2012 in my earlier example). So usually if I've made a good gain and I'm getting a little closer to the maturity date, I'll sell them to lock in the gain. It's not like stocks where you can hold for the long run.

  • Report this Comment On June 04, 2010, at 11:54 PM, biotechmgr wrote:

    Great to finally see a real discussion of short selling. People here are going to need it.

  • Report this Comment On June 05, 2010, at 10:23 AM, plange01 wrote:

    for the average to mid level investor the only short selling should be in buying a occasional etf that specializes in certain areas.with the US stock market in a state of collapse the only stock any level investor should be looking at right now is symbol...CASH...

  • Report this Comment On June 05, 2010, at 9:13 PM, susan400 wrote:

    see TMF 2/21/2003

    timing !!!!!!!!!!!!!!!!!!!

  • Report this Comment On June 05, 2010, at 11:27 PM, park94 wrote:

    If you're an "investor" and don't already know what shortselling is do yourself a favor; cash out and go spend your money elsewhere. It will be more rewarding.

  • Report this Comment On June 11, 2010, at 3:47 PM, philkek wrote:

    Thanks to all M.F. commentators here on subject of short-selling. I've gained a little more knowledge in financial matters in these writings from you smart fools. If I'm going to be a losing fool at least I can't say I wasn't warned. CASH may be best position for me to hold now. ETFs offer diversity for my money. I'll do the homework from the Foolish guide to the best of my ability. M.F. comments concerning Mr. Market will help me decide my next moves. Feels good to be in the company of winning fools. Fool on.

  • Report this Comment On June 15, 2010, at 1:20 AM, Jahnavipat wrote:

    Like anything, you have to study how to do these things correctly before employing these strategies, but TMF is a great place for that (the articles linked above look like a great place to start). Frankly if I didn't have short positions down right now, I'd be staying awake at night out of nervousness that I'd wake up the next morning every day with a lower portfolio.

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