Short-Selling Can Leave You Short

Short-selling is a necessary component of the market. Without it, stock prices would reflect only optimism -- a dangerous prospect, in extreme quantities. However, I can't really recommend shorting to individual investors, and I don't practice it myself. It's a quick and easy way to lose your shirt.

Fortunately, I've found an easy way to test my short theories. Look no further than my record in Motley Fool CAPS for a lesson in how dangerous it can be to be wrong (or early) when shorting stocks.

Lessons in sensible shorts
Investors, pundits, and corporations like to villify the act of short selling, but smart short sellers often uncover danger signals in companies. Enron is one good example. Michael Lewis's new book, The Big Short, also chronicles how some folks saw the signs of the housing bubble, even as too many players were locked in boundless optimism. Those who realized the complete reality disconnect of the bubble shorted it and profited hugely.

Always be wary of those who try to blame shorts for any bearish drag on a company's stock; that pessimism may be rational. In March 2008, a representative of now-defunct Lehman Brothers said: "There are a lot of rumors in the marketplace that are totally unfounded. We are suspicious that the rumors are being promulgated by short-sellers of our stock that have an economic self-interest." We now know those rumors were, in fact, very much founded.

This is a test; this is only a test
Investors who'd like to test out their bearish theories without risking their real money can learn some good lessons in CAPS by using the thumbs-down "underperform" button on stocks.

I've ridden out some interesting rollercoasters from the safety of our online investing community. Years ago, I found myself hundreds of points in the red on Crocs (Nasdaq: CROX  ) , which looked like an overpriced fad stock, but kept zooming higher. When Crocs' problems finally came to light, I was able to close the pick with a positive score. (At the moment, I'm down more than 200 points on a subsequent underperform call on Crocs. Even though Crocs seems to have gotten itself off the endangered species list, I'm still skeptical that it can ever manage the growth of yesteryear.)

A rally like last year's can also illustrate how difficult short-selling can be when optimism runs rampant. Abercrombie & Fitch (NYSE: ANF  ) still faces major challenges, and remains mired in shareholder-unfriendly behavior, yet its stock has soared 106% since my "underperform" call in December 2008.

One of my biggest stinkers is an underperform on Limited (NYSE: LTD  ) , which I examined in March, noting a high debt load, fewer eggs in its basket of retail concepts, and flagging revenue. It's up 233% since I put the red thumb on it in December 2008.

That hasn't stopped me from trying again. We'll see how my very recent underperform call on BP (NYSE: BP  ) goes. Given its shameful response to the Gulf Oil spill, and the specter of huge and increasing liabilities and regulatory scrutiny, I decided to go ahead and put a red thumb on the stock, even though it's already lost about a third of its market value. Some observers insist it's now cheap, but I'm not convinced, and I don't think management's actions or attitudes bode well for long-term investors.

Proceed with caution
I've had some red-thumb victories in CAPS, including still-struggling Borders Group (NYSE: BGP  ) . But as my imaginary shorting catastrophes sugges, with real-life capital, individual investors truly risk losing their shirts with shorts. You might not even be wrong -- just early, or at the mercy of a rally driven more by hope than by reality or honest fundamentals.

And of course, if you're long, a stock can only go to zero. In theory, losses on a short can be infinite. Investor, beware.

What do you think of short selling? Fire away in the comments box below.

Alyce Lomax does not own shares of any of the companies mentioned. The Fool has a disclosure policy.


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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 5:34 PM, longtermgrowth09 wrote:

    Alyce very interesting article i read all your sections regularly and what do you think to the fact that woman investors are outperforming male ones in the stock market consistently over the years?

  • Report this Comment On June 04, 2010, at 5:35 PM, longtermgrowth09 wrote:

    what do you think to the fact that woman investors are outperforming male ones in the stock market by being prudent and long term focus ?

  • Report this Comment On June 07, 2010, at 12:22 PM, TMFLomax wrote:

    Hi longtermgrowth09,

    Thanks for reading my articles! And I recall reading about that data about female vs. male investors in the past. Is there new data on that? It's very interesting and something to ponder for sure.

    Best,

    Alyce

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