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<< What is sellshort?>>

Here's an explanation I prepared for our weekly newspaper feature (more on our feature:

Hope it helps!


The Fool School

The Long and the Short of It

"Buy low, sell high." This is a common mantra for those who are "long" on stocks, meaning they've bought shares expecting the price to rise. Some intrepid folks sell stock "short," though, expecting the price to fall. If it does, they will profit.

To understand how shorting works, consider Tonsiltime Inc., the drive-through tonsil-removal company. You think this company is way overvalued and expect its share price to tumble soon.

To short Tonsiltime, you call your brokerage house and say you want to sell some shares of Tonsiltime short. The brokerage will "borrow" them from a Tonsiltime shareholder's account and then sell them for you. Then, once the share prices drop, you'll "cover" your short, buying shares on the market at a lower price, to replace the ones you borrowed. If you shorted Tonsiltime at $18 and covered when it fell to $12, you made $6 per share (less commissions).

Although this might sound fishy, don't worry. It's perfectly acceptable and done often. When shorting, you're still aiming to buy low and sell high, but you've simply reversed the order, selling before buying.

Shorting allows you to profit from both rising and falling stocks. It can also bolster a portfolio, should the market drop significantly. However, since it's based on short-term expectations, it bucks the overall upward trend of the market. In addition, 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.

A final and important consideration is that with shorting your upside is limited to 100%, since a stock price can't fall lower than zero. But if your short just 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. If you're new to investing, shorting isn't for you. Even if you're experienced, you may want to give the approach short shrift -- unless you run across a business model as flawed as drive-through tonsil removal, that is.
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