5 rules for selling short

• No new trades.

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"Keep on going, and the chances are that you will stumble on something, perhaps when you are least expecting it. I never heard of anyone ever stumbling on something sitting down." -- Charles F. Kettering

One of the fundamental goals of Strategy Lab is to share ideas on how individual investors can make money. Today I want to offer some thoughts on short selling, a process that can help average investors protect their hard-earned gains during a bear market.

For those unfamiliar with the concept, let's begin with a definition of short selling from the Fast Answers section of MSN Money:

Short selling is borrowing an investment and selling it, knowing that later you will have to buy it again so you can return it. In other words, selling short is selling something you don't really own.

You might sell short when you believe the price of a stock will fall in the short run and you want to profit from the drop. Selling short is very risky. Stocks tend to rise over time, so being a short seller requires good market timing.

Here's how short selling works: Say you want to sell short 100 shares of a stock that you think is about to drop. Your broker borrows the shares from someone who owns them, promising you will return them later. You sell the borrowed shares at the current market price. When the price of the shares drops (you hope), you "cover your short position" by buying back the shares at the lower price, and your broker returns them to the lender.

Your profit is the difference between the price at which you sold the stock and your cost to buy it back, minus commissions and expenses. If you're wrong and the stock price skyrockets, your potential losses are unlimited. You must buy the stock back at the market price to cover your short sale, no matter what they cost.

Don't blame the short sellers

Every few weeks or so, the news media seem to pick a new story about some "evil" hedge fund manager who is trying to bankrupt another "great" company by engaging in a very "questionable" practice of short selling.

Recently, bond insurer MBIA (MBI, news, msgs) wrote a letter to the Senate that in effect blamed hedge fund managers for some of the troubles bond insurers have gotten themselves into. The company complained that short sellers such as Bill Ackman, the founder of Pershing Square Capital Management, have sought to undermine investors' confidence in the insurers.

Do MBI's top managers seriously think the company's stock price has declined because of short sellers, rather than because of the fundamental issues with its business model? What a joke! These guys need to grow up, stop crying and instead focus their efforts on trying to figure out how to save their company and reputations from what looks to have been a string of serious errors in strategic thinking and business judgment.

Why short selling is important

I believe short selling is not only ethical but also a very necessary financial transaction that not only helps to keep markets from being irrational for prolonged periods of time, but also makes sure that incompetent managements' messes do not go unpunished for too long, by bringing a healthy dose of fear into their often unreasonably greedy and self-centered actions.

But now let's get back to the initial target of our discussion: learning how an average investor can and should benefit from selling short. Let me start by saying that I do not think that an average investor should use short sales as a primary tool of making money. That would be a pure speculation rather than investing.

Your odds of beating the market in the long haul with a 100% short-only portfolio are quite slim. The main reasons for that are quite simple: Though your upside is effectively capped at 100%, your downside is theoretically unlimited.

In the long term, stocks prices go up -- period. The doom-and-gloom theories are always short term in nature, as it is simply impossible for prices to go down forever because of the simple little fact called inflation. Though "real" stock prices could possibly go down for a long period, nominal prices will go up in lock step with inflation.

So here is my take on what the primary goal of "rational" investor short-selling strategy should be: It is simply called risk mitigation or hedging. It is a very prudent practice for average investors to allocate a healthy portion of their portfolios -- usually no more than 30%-40% of their "long" holdings -- to a well-diversified group of small short positions. These stocks are intended to serve a primary goal of cushioning portfolio gains in the event of a severe market decline like the one experienced over the past several months.

Assuming that you also you shorted the right stocks (usually on the downtrend already and highly leveraged), this 30%-40% position could potentially cushion the majority of your "long" losses, even though the actual dollars committed to the shorts smaller, because "weak" stocks tend to fall off the cliff much faster than blue-chip names. Yes, during a bull market your short positions could exhibit a small drag on your upside, but it is likely to be small if executed correctly and will reduce the overall volatility of your portfolio.

Continued: The right way to short

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