Short-selling strategies.

Selling short involves tail risks

Arising tide does not necessarily lift all boats. In the spring of 1999, he leading stock market averages were at record levels, led by technology stocks. Nevertheless, there were losers as well as winners, even in the tech area. "For example, MicroWarehouse was selling at around $17 per share, down from a 52-week high of $47," says Jonathan Moreland, director of research for InsiderTrader.com, a financial Website with headquarters in New York City. "Short sellers made substantial profits there."

That is, investors who bet that MicroWarehouse's stock would fall engaged in "short selling" and reaped huge profits. Other overvalued stocks may be ready to collapse, presenting lucrative opportunities. Nevertheless, selling short is a high-risk exercise that's only for the most sophisticated trader.

In essence, selling short is the reverse of buying and then selling a stock: you sell something you don't yet own. To sell short, you borrow shares from your broker and sell them today, at the current [and, you hope, inflated] price. "Your broker might obtain the stock from the firm's inventory, from another broker or from another customer's margin account," says John Guy, president of Wealth Planning & Management L.L.C., a money management firm in Indianapolis. The broker sells those shares and holds the proceeds to secure your loan.

At a later date you will have to buy the same number of shares to replace the stock you borrowed. Your expectation is that the price of the stock will decrease so that you can buy the shares for, say, $17, a lower price than the $47 you sold them for, thus making a profit. This is called "covering" your short sale. You close the position by buying an equivalent amount of the stock and delivering the shares to your broker, who will use them to repay the loan.

However, you may have to cover after the stock has risen to cut your loss. When many short sellers cover in this manner, the increased buying pressure drives up the stock price, which leads to still more covering by short sellers, which leads to even higher prices, and so on. The result can be huge losses for the short sellers who are slow to cover.

And if the stock price increases, you lose. "When you sell short, your potential loss is infinite," says Guy. "When you purchase a stock, the price may go down, but no further than zero, and so there is a limit on the amount of loss you can sustain." But there's virtually no limit to a stock's price when it starts moving higher, so your loss can be much greater if you've sold the stock short. "The higher the price, the greater the loss if you have sold the stock short."

When shorting a stock, you have to pay a commission to your broker for each transaction--one when you sell and another when you buy. "You must have a margin account to sell short and you'll pay interest on the amounts you borrow," says Antoine Sylvas, an investment specialist with Charles Schwab in San Francisco. "Interest rates on margin loans at our firm are as high as 8.75% now, although those who borrow large amounts pay less, down to 7.25%"

Sylvas says that you'll have to keep 50% margin in your account in most cases: if you sell short $20,000 worth of stock, for example, you'll have to keep $10,000 worth of cash or other securities in your account. If the stock price moves up, you'll have to put in more cash or securities as additional margin.

Given all these risks, when might it pay to short a stock? "Only when it's grossly overvalued," says Guy. Moreland says that the best single indicator he has found is heavy insider selling of a stock that is trading at a price well below its 52-week high. "I remember seeing that pattern at Discovery Zone, a company that offered play space for children" he recalls. "when I questioned the CEO, he expressed surprise at how seasonal his business was. I decided this was a company that didn't really know its market, and it proved to be a successful short sale."