Most people who buy stocks expect their prices to rise. In market terms, they're "going long" on those investments. But that's not the only way to make money on stocks. The folks on the flipside of every "long" investment, betting that your stock will fall, can still affect how your holdings perform.
The long and the short of it
Those who "short" stocks still subscribe to the market's guiding "buy low, sell high" principle. They simply do so in reverse: Sell high, then buy low. Here's how it works.
Suppose you believe that dogsled-delivery specialist Iditarod Express (ticker: MUSHH) doesn't have a snowball's chance of market success. Confident that it will fall, you place an order to short it. Your brokerage "borrows" shares from someone who already owns the stock, then sells those borrowed shares on the market and gives you the proceeds. (You've just "sold high.")
Now, let's say that the stock falls sharply within a few months. You can then "cover" your short by buying shares on the market to replace the ones you borrowed and sold. (Now you've "bought low.") You pocket the difference between the high sale price and the lower purchase price -- a beautiful way to make money on losing stocks.
There's just one problem: You won't always be right. Some stocks that may seem ridiculously overvalued will just keep rising. If you give up and cover your short at a higher price, you'll lose money. And while in conventional investing, a stock can only fall by 100%, with no limit on its potential rise, the reverse applies to shorting. You can only make up to 100% if your stock implodes, with no hard limit on your losses if it keeps rising.
You can go through a successful investing career without ever shorting any stocks, yet still be affected by those who short. If lots of people have shorted a company you own, and many of them start covering their positions by buying shares, their repurchases will drive your share price higher -- what the market calls a "short squeeze."
You should never buy a stock simply because it's heavily shorted, in hopes of benefitting from a short squeeze. After all, the shorts may be right, and the stock might fall. But it doesn't hurt to see which companies you own are heavily shorted. You need to know whether the market thinks poorly of your stock, and prepare yourself for any potential short squeezes.
The following companies rank among those beset by significant naysayers:
Shorted Shares as a % of Float
Northern Oil and Gas
Data: Bespoke Investment Group.
Each of the companies above has its bears and bulls. Savient Pharmaceuticals has already dropped more than 40% over the past year. Investors were undoubtedly disappointed when Savient gave up on trying to sell itself to Pfizer
Fans of Entropic Communications are excited about its business: helping to connect consumer devices to the Internet. Between now and 2015, the number of televisions with Internet access is expected to soar from 60 million to 500 million, per the folks at DisplaySearch.
Northern Oil and Gas is promising because of the oil-rich Bakken shale reserves in North Dakota, but some worry that those supplies will dry up quickly. Northern's CEO has also sold large amounts of stock, which could signal insiders' believe that the shares have become overvalued. In fairness, that's not necessarily a bad thing. Many bigwigs get paid largely in stock, and they'll occasionally sell it to raise some cash.
Ebix, which provides software for the insurance industry, has had a choppy year tarnished with allegations of fiscal shenanigans. Those charges come from a short-seller, who's therefore not exactly objective, but any such accusations always merit your further research. Still, the company is a recommendation in two Motley Fool newsletters, and it's been posting strong earnings and revenue growth.
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Longtime Fool contributor Selena Maranjian owns shares of Ebix and Entropic Communications, but she holds no other position in any company mentioned. Click hereto see her holdings and a short bio. The Motley Fool owns shares of Best Buy and Ebix. Motley Fool newsletter services have recommended buying shares of Best Buy, Pfizer, and Ebix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.