Don't Be Scared Out of Your Shorts About Shorting

This article is part of our Better Investor series, in which The Motley Fool goes back to basics to help you improve your returns and be more successful with your investing.

Shorting stocks is one of the most vilified, confusing, and intimidating practices in investing. Most retail investors only buy shares, and when a stock falls, they often blame short-sellers. But shorting definitely isn't all bad -- and there might even be a place for it in your portfolio. Here's how shorting works, and how to make it work for you.

Blame the shorts, ask questions later
There are a lot of misconceptions about shorting stocks, because shorting's often publicized only when a company gets into trouble. Lehman Brothers' short-sellers got a lot of attention when hedge fund manager David Einhorn took a very public short position in the company in 2008. This year, Europe even imposed a partial ban on short-selling bank stocks. At the moment, short-selling interest on Bank of America (NYSE: BAC) has soared, as many investors think that the bank's days are numbered.

But shorting stocks is neither evil nor morally wrong. In fact, it's an important part of creating efficient markets and a balanced portfolio. It certainly has its downsides, but short-selling is a normal part of the market's efficiency.

The mechanics behind the other side of investing
Short-selling is intimidating in part because not everyone can sell stocks short. To short stocks, your broker has to approve you for a margin account, which sounds intimidating and risky. But shorting isn't incomprehensible, and it can actually reduce portfolio risk. How does it work?

When you sell a stock short, you actually borrow shares from a broker, who is holding the shares for someone else. Then you sell those shares to another buyer on the market. This leaves you with cash in your account, and a liability equal to the value of the stock you've sold. If the stock goes down, your liability goes down, and you can keep the extra cash. If the stock goes up, you'll be on the hook to pay back more money than you initially made from selling the shares.

A simple short-selling strategy
Today, I'll focus on one of the most common short strategies: a long/short paired trade. Here, you buy one stock, then offset that by shorting another stock. This trade is "market neutral," meaning that whether the overall market rises or falls matters less than how your long and short perform compared to each other.

Typically, investors choose stocks in similar industries that may be over- or undervalued, or have different growth rates. For example, retailers Best Buy (NYSE: BBY) and Amazon.com (Nasdaq: AMZN) are two very different companies. Best Buy's P/E ratio and price/book value are much lower than Amazon's. But Amazon has a big lead in online retailing, and it's grown much faster in recent years. If you think that Best Buy can catch up in that department, then Best Buy would arguably be a steal at today's price.

Source: Yahoo! Finance.

The risks of this trade: What if Amazon's higher growth rate continues? And what if Best Buy keeps struggling with its brick and mortar stores?

One of my favorite paired trades to watch has involved Apple (Nasdaq: AAPL) and Netflix (Nasdaq: NFLX). Apple actually has had a higher growth rate than Netflix, and its shares are less expensive based on P/E ratio. This would suggest that buying shares of Apple, and offsetting them with a short position in Netflix, could make a perfect long/short trade.

Source: Yahoo! Finance; Capital IQ.

This pair reveals one of the major risks of short investing: irrational exuberance. You could argue that Netflix is vastly overvalued. However, despite all logic, the stock could keep rising, leaving you on the losing side of that trade.

Sell, sell, sell
If you have the conviction that a company or sector is headed south, you probably don't want a pairs trade in the first place. That's where plain old shorting comes in.

In the past, I have shorted MGM Resorts (NYSE: MGM), because my research told me that the stock was terribly overvalued. I could have offset the position with a gaming company like Melco Crown or Las Vegas Sands (NYSE: LVS), but I had enough confidence to short MGM without offsetting the trade.

Part of a bigger picture
Among their other benefits, short positions can help reduce volatility in a balanced portfolio.

Suppose you have a $10,000 portfolio, fully invested in long positions that exactly follow the market. In the scenario below, we offset that long bet with two portfolios whose short positions move exactly opposite the market. In one of those portfolios, shorting positions equal 25% of the long holdings, balancing that $10,000 in stock with $2,500 in short-sales. The other portfolio's short position equals 50% of its long holdings. If stocks drop 20%, look at what happens:

Source: Author calculations.

You can see that portfolios with short positions beat the market. Of course, the opposite holds true if the market moves higher. Even so, the portfolio's overall volatility should (hypothetically) be lower.

Seller beware
There are several nuances to short-selling that you should look into before you sell anything short. Make sure you know how to manage a margin account, and what to do if your holdings get hit with a short squeeze. Your broker will have details on how shorting works, and you'll find that each broker does things a bit differently.

But in general, the basic rules of shorting are very similar to buying stocks: Do your homework, develop an investment thesis, and constantly research to keep that thesis up to date.

Do you still have questions about shorting stocks? Post your query in the comments section below, and I'll do my Foolish best to make sense of the "other" side of investing.

Stay tuned throughout our Better Investor series and get the advice you need to succeed with your investments. Click back to the series intro for links to the entire series.