Fool's School The Scoop on Shorting

You know all about buying low and selling high, right? Did you know you can also make money by reversing that? Sell high and then buy low, and you're engaging in "shorting."

Imagine that the Meteorite Insurance Co. (ticker: HEDSUP) has gone public. Despite general excitement about the firm, you have little faith in it and expect the stock to sink. You call your brokerage and say that you want to short HEDSUP. The brokerage will "borrow" shares from a HEDSUP shareholder's account and sell them for you. Then, assuming the share price does drop, you'll later "cover" your short, buying shares on the market at a lower price to replace the ones you borrowed. If you shorted HEDSUP at $50 and covered when it fell to $40, you made $10 a share (less commissions). This technique may sound weird, but it's legal and done often.

Shorting can be beneficial because with shorts in your portfolio, you might profit from any kind of market. If the market takes a big drop, your shorts will likely fall, boosting your portfolio's performance. If you see a stinker of a company, you can profit by betting against it.

But shorting has a big downside, too. If the stock price rises, you lose. With shorts, you can earn only up to 100 percent, since a stock price cannot fall lower than zero. But if your short keeps rising (going in the wrong direction), your downside is theoretically unlimited. Since you can actually lose more than 100 percent of your money, you need to keep a close eye on any shorted stocks.

Other reasons to think twice before shorting: Shorting bucks the overall long-term upward trend of the market. Sometimes, companies you are sure are overvalued just keep going up anyway. And 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.

Shorting can be effective, but it's only for seasoned investors. Many experienced investors do well without it, too.