You're probably familiar with the investing mantra "buy low, sell high." You might not know it, but if you've spied a stock you're pretty sure will tank, there's an interesting way you might profit from its fall. You'd reverse the old saying -- by selling high and then buying low. This is 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 the company 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. The proceeds of the sale go into your account. 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 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.
- Hey, if you find a stinker of a company that you're confident is wildly overpriced and doomed to fall, why not make a few bucks on it?
Shorting has its negative side, too, though:
- If the stock price rises, you lose. With shorts, you can only earn 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.
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.