Before You Short

By Michael Shulman

Brokers are able to handle most shorting requests, although selling short is a little more complicated then going long and buying put options.

That being said, there are some major issues you need to understand before going short. Most of these relate to the actual shorting of a stock, not buying puts.

Risk

In a long position, the most you can lose is 150% if you borrowed on margin to leverage your investment. With a short position involving the borrowing of the stock, your theoretical potential loss is unlimited. If you borrow a stock when it is trading at $10 and the stock runs up to $200, then you are out $190 a share -- 19 times your original investment! Which is not a good thing.

The Margin Account

You need to open a margin account to short a stock. It is in this account that the funds from your sale of borrowed stock will be placed. But don't count on collecting interest on this money. Not only will the broker charge you interest on the shares you borrowed (unless you are Warren Buffett or the CEO's cousin), they will not pay you interest on the funds in the account or sweep it into a money market fund.

Finding the Stock

You may want to short a stock that is hard to find. The process of finding shares is called a "locate." If your broker cannot find them, then you cannot short the stock. It is also virtually impossible to short a stock with a price under $5, and you cannot short a stock within a specified period from its IPO, depending on the exchange the stock trades on.

Margin Calls

If the price of the stock you have shorted rises, your broker will ask you to put more funds in this account, typically enough to cover the purchase of the stock on the open market at the current price. If you don't make the payment asked for by your broker, and you have other securities held long in that margin account, the broker will sell those securities to meet the margin call.