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Investing 101: The Art of Selling Short

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There's more to "short selling" than meets the eye. In this edition of Investing 101, we take a look at the basics of shorting, what it is, how it works and who might do it. To help us along, we brought in Tim Smith, senior vice president at Sungard's Astec Analytics, a market data firm specializing in securities lending and borrowing.

1) What is Short Selling?

"It's the opposite of long buying," Smith says in the attached video, explaining that when people buy securities, they think the price may go up. But when they sell a security short, he says "they do that because they think the price may go down." On Wall Street, there are several different iterations of shorting, but they all essentially mean the same thing; that a stock or index is overpriced and expected to go down in value. "It's another investment management technique,'' Smith says.

2) Who Should Sell Short?

While this practice of bearish bets is open to anyone, Smith says it is "really a game best left to the pros" simply because the risks surrounding shorting can be huge. "The argument goes that the downside for short selling is infinite," Smith points out, "and by that I mean, if you think the price of a share is going to go down and you put on a short position, the price could actually go up, and it could go up to infinity." For example, if you buy a $20 stock and it just goes completely out of business, the most you could loose by being long - and wrong - is $20. The flip-side of this is if you are short a stock at $20, the most you could make is $20 if you were right and that stock indeed went zero. But the catch, or mismatch, is if you're short - and wrong - that $20 stock could, theoretically, go to $1 million or more, so your ultimate exposure or risk is infinite.

3) Why Is Short Selling So Controversial?

Investors may have noticed that, during the throws of the European debt and banking crisis, several countries initiated temporary bans on the short selling of banks. While the goal of such rules is to maintain orderly markets, many pros would argue that the opposite effect is true since the ban simply highlights the underlying vulnerability, and shorting potential, of the entity being protected. Whether they are ill-fated or note, to be fair, the short bans in Europe were no different than those implemented by U.S. regulators during the recent financial crisis.

4) What is Naked Short Selling

In the words of Tim Smith, naked short-selling is simply the street term for "uncovered short selling", which he explains is when an investor decides to sell a security short but doesn't make pre-arrangements to borrow it so they can pay it back and deliver the share borrowed when the trade is closed out. As a result, naked short selling is illegal and deemed to be a practice rife with manipulation, or as Smith says, "the argument goes that in a bad economy, (naked short selling) can lead to companies being driven of out of business"

5) How Can the Average Investor Go Short?

The most common way for investors to place these type of bearish bets is through ETFs, or exchange traded funds, where there are literally dozens of offerings designed to track a decline in stocks, bonds, indexes, commodities or currencies. In some cases, these short funds are also leveraged so that they offer investors two or three times the return, but arguably carry a commensurate increase in risk. As for some of the most common short ETFs, ProShares Short S&P 500 (SH), or the Proshares Short Dow 30 Industrials (DOG) are both very popular and actively traded, but there are many, many more available that cover all sort of investment possibilities.

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