Short Stocks Without Losing Everything

Lately, short-selling has gained in popularity as a great way to earn big profits when stocks go down. What sometimes gets lost in the shuffle, though, is the risk that can lurk in short-selling.

But even though selling stocks short creates the potential for huge losses, one simple strategy can help you limit your risk and still reap the benefit of a bet against a particular company.

Preventing monumental losses
There's a lot to be said for adding short-selling to your investing arsenal. As fellow Fool Matt Argersinger recently uncovered, when you look at stock returns from 1983 to 2006, you'll find that nearly 40% of stocks lost money during that period -- and nearly one in five lost 75% or more of their value.

But short-selling carries a big risk. When you buy stocks, even if everything goes wrong, the most you can lose is the money you invest in the first place. Even if the company files for bankruptcy and owes billions more to creditors than its assets are worth, those creditors won't come after you for the difference.

Short-selling, on the other hand, has the potential for much bigger losses if your bearish call turns out wrong.

During the worst of the financial crisis a couple years ago, many believed Ford (NYSE: F) would inevitably follow peers GM and Chrysler into bankruptcy, because of its huge overhanging debt load. But if you shorted $1,000 worth of shares on the last day of 2008, you would have lost more than $4,200 during the past year and a half, as the company continues to execute its turnaround.

And if you made the same mistake with Sirius XM Radio (Nasdaq: SIRI), thinking that its long history of never having made a profit would continue, you'd have a $7,800 loss on your $1,000 short of a company that is now, finally, free cash flow-positive.

Needless to say, you can't afford multibagger losses very often. So how can you make sure that when selling short goes horribly wrong, it won't take your portfolio down with it?

Enter options
One way to reap the benefits of short-selling while limiting your losses is by combining short-selling with a simple strategy using options. In particular, by buying call options, you can ensure that you'll have the ability to cover your short position at the price you specify, no matter how much higher the stock may trade in the future.

Here's an example of how the strategy works. Say you think that AstraZeneca (NYSE: AZN), which is banking on its blood thinner drug Brilinta gaining FDA approval tomorrow, won't get that approval because of discrepancies between its international and U.S. trial results.

You could short the stock now, but that'd leave you exposed if the FDA does approve the drug and the stock jumps. If, however, you also buy call options giving you the right to buy shares for $55 anytime between now and mid-October, you'd limit your loss to less than 5%. And those options would cost you just $0.44 per share.

Similarly, fellow Fool Jordan DiPietro recently listed several popular short picks that trade at very high multiples, but which he believes could easily backfire on short-sellers. If you still think they're good short candidates, but want to protect yourself, here's how call options could help:

Source: Yahoo! Finance. As of Sept. 14 market close.

It's true that protection doesn't come free. In the best case, you fully expect to lose everything you pay for your call option, since you expect the share price to drop. But paying a few percentage points of the stock's value may be worth it to you to prevent the possibility of a 400% or 800% loss.

What's the best move?
When figuring out which stocks are most likely to be profitable short candidates, while limiting your potential losses, you'll want to look for a combination of factors.

High valuations and unrealistic expectations are nice to see, but for great shorting opportunities, you'll also want to look for companies with troublesome traits. Unreliable accounting, management problems, and insurmountable business challenges are just a few of the things to watch for.

To learn more about finding stocks with potential profits from shorting, you'll want to take a look at a new report from leading forensic accountant John Del Vecchio. To get a free copy of his "5 Red Flags -- How to Find the Big Short," just enter your email address in the box below.