Selling Short

Some stock investors take added risks in the hope of greater returns.

Not all stock trades are straightforward buys or sells. There are several strategies you can use to increase your gains, though they also increase your risk of incurring losses. Among these strategies are selling short and buying warrants. Both are based on a calculated wager that a particular stock will change in value, either dropping quickly in price � for a short sale � or increasing, for a warrant.

How Short Selling Works

While most investors buy stocks they think will increase in value, others invest when they think a stock's price is going to drop, perhaps substantially. What they do is described as selling short.

To sell short, you borrow shares you don't own from your broker, order them sold and pocket the money. Then you wait for the price of the stock to drop. If it does, you buy the shares at the lower price, turn them over to your broker (plus interest and commission) and keep the difference.

For example, you might sell short 100 shares of stock priced at $10 a share. When the price drops, you buy 100 shares at $7.50 a share, return them to your broker, and keep the $2.50-a-share difference � minus commission. Buying the shares back is called covering the short position. In this case, because you sold them for more than you paid to replace them, you made a profit. And you didn't have to lay out any money to do it.

You borrow 100 shares at $10 per share from your broker
You sell the shares at the $10 price getting $1,000
	You profit if stock price drops	You lose if stock price rises
Stock price	$7.50	$12.50
Shares you owe your broker	100 Shares	100 Shares
Your cost to pay back the shares	$750	$1,250
Profit or loss	$250 profit	$250 loss

What are the Risks?

The risks in selling short occur when the price of the stock goes up � not down � or when the drop in price takes a long time. The timing is important because you're paying your broker interest on the stocks you borrowed. The longer the process goes on, the more you pay, and the more the interest expense erodes your potential profit.

An increase in the stock's value is an even greater risk. If it goes up instead of down, you will be forced � sooner or later � to pay more to cover your short position than you made from selling the stock. That means you lose money.

Squeeze Play

Sometimes short sellers are caught in a squeeze. That happens when a stock that has been heavily shorted begins to rise. The scramble among short sellers to cover their positions results in heavy buying, which drives the price even higher.

Short Interest Highlights

Trading activity in stocks that have been sold short on the New York Stock Exchange and the American Stock Exchange and not yet repurchased is described as short interest. The volume of short interest gives you a sense of how many investors expect prices to fall, and the stocks they expect to be affected.

Selling short often increases when the market is booming. Short sellers believe that a correction, or drop in market prices, has to come, especially if the overall economy does not seem to be growing as quickly as stock values are rising. But short selling is also considered a bullish sign, or a predictor of increased trading, since short positions have to be covered.

The average daily volume, which is the average number of shares sold short each trading day during the month, and the percentage change during the month are reported in the financial press for each company that has had at least 550,000 shares sold short or a change of short interest of at least 250,000 shares in the month.

In addition, graphs track the recent history of short interest and summary tables provide the names of the companies with the largest short positions and the greatest change. You may also find a graph showing the short interest ratio. That's the number of days it would take to cover the short interest in selected stocks if trading continued at a consistent pace.

Buying Warrants

Like a short sale, a warrant is a way to wager on the future price of a stock - though a warrant is less risky. Warrants guarantee, for a small fee, the opportunity to buy stock at a fixed price during a specific period of time. Investors buy them if they think a stock's price is going up.

For example, you might pay $1 a share for the right to buy a stock at $10 within five years. If the price goes up to $14 and you exercise, or use, your warrant, you save $3 on every share you buy. You can then sell the shares at the higher price to make a profit [ $14 - ($10 + $1) = $3 ], or $300 on 100 shares.

Companies sell warrants if they plan to raise money by issuing new stock or selling stocks they hold in reserve. After a warrant is issued, it can be listed in the stock columns and traded like other investments. A wt after a stock table entry means the quotation is for a warrant, not for the stock itself.

If the price of the stock is below the set price when the warrant expires, the warrant is worthless. But since warrants are less expensive than purchasing the stock outright and have a relatively long lifespan, they are traded actively.