You're probably familiar with this investing mantra: "Buy low, sell high." You might not know it, but if you've spied a stock that you're pretty sure will tank, there's an interesting way in which you can profit from its fall. You'd reverse the old saying -- by selling high and then buying low. This is called shorting a stock.
Here's how it works. Let's say that an Internet fan club, GroverCleveland.com (ticker: GROVY), has gone public. Despite much media hoopla, you have little faith in it and expect the stock to sink. You call your brokerage and say that you want to short GROVY. The brokerage will "borrow" shares from a GroverCleveland.com shareholder's account and proceed to sell them for you at the current high price. Then, once the share price drops, you'll "cover" your short by buying shares on the market at a lower price, to replace the ones you borrowed. If you shorted GROVY at $35 and covered when it fell to $20, you made $15 per share (less commissions).
This technique sounds weird, but it's perfectly acceptable, and it's done often. Shorting can be beneficial because:
- With shorts in your portfolio, you might profit from both rising and falling stocks. If you see a great and growing company, you can buy shares in it. If you see a stinker, you can profit by betting against it.
- Shorting can bolster a portfolio. If the market takes a big drop, your shorts should boost your portfolio's performance.
Shorting has its negative side, too, though:
- If the stock price rises, you lose. With shorts, you can earn only up to 100%, since a stock price can't fall lower than zero. But if your short keeps rising, your downside is theoretically unlimited. Since you can actually lose more than 100% of your money, you need to keep a very close eye on any shorted stocks.
- Shorting is based on short-term expectations, and Fools generally prefer to focus on the long term.
- It bucks the overall upward trend of the market.
- If you short a company, you'll have its management working against you to make the company succeed, perhaps with new financing, partnerships, or products.
- If the stock you shorted pays dividends, you'll be required to pay the dividend to the shareholder whose shares you borrowed. (Your broker will usually take care of this.)
Shorting can be effective, but it's only for seasoned investors. Even experienced investors may want to avoid it -- unless they run across a business as unpromising as GroverCleveland.com, that is.
Read up on shorting in our FAQ, our 13 Steps (scroll down for shorting), and in this classic article by Jeff Fischer. You can also share shorting ideas with fellow Fools on our Shorting Stocks discussion board.
Here are a few more Fool articles related to shorting:
- The Long and Short of It
- Coming Up Short
- The Art of Shorting
- Learn to Respect Shorts
- The Naked Truth on Illegal Shorting
- Who's Behind Naked Shorting?
By the way, if you'd like to receive several promising stock ideas delivered via email each month, learn more about our suite of investment newsletters, which we offer along with some free research reports. Our newsletters' performance may surprise you. You can also learn all about brokerages and find one that's right for you in our Broker Center.