Jon Lewis

The Best Way to Short Stocks

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Short sellers tend to get a lot of bad press -- and a lot of blame when stocks go down.

A while back, an editorial in Kiplinger's that caught my eye talked about the pitfalls of short selling, focusing primarily on the difficulties of finding the right stocks to short. The bottom line, the article claimed, is that the odds are stacked against you.

Well, OK, stocks go up on average over time, the last decade notwithstanding. (Did you know that the S&P 500 is at the same level as late 1997?) And, yes, you can find bear funds that have done poorly over time. No argument there.

But c'mon, let's be fair. Unless your strategy is to buy a broader-market index fund (or ETF) and walk away for 10 or 20 years, why would you dismiss a strategy that has merits? The market goes up and down. Why not take advantage of the "down"?

But I don't want to argue the merits or pitfalls of short selling and whether you should do it. Rather, I want to focus on the best way of shorting stocks.

The Pitfalls of Shorting a Stock

The traditional way of shorting involves borrowing shares from your broker and selling them in the open market. Clearly, you want the value of the stock to decline, so you can buy the shares back at a lower price. Your profit is simply the price sold minus the price purchased -- pretty straightforward.

But what happens if the stock goes up in price? Your losses start to mount and mount. In fact, your loss is theoretically unlimited, because there's no limit to how high a stock price can travel. So your loss is capped only when you buy the shares in the open market.