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Short-selling holds benefits, grave risks

Potentially lucrative strategy has unlimited loss potential

Knight Ridder Newspapers

With stocks on a roller coaster that has generally headed downhill this year, some investors are looking for ways to hedge their bets, making money when shares go down as well as up.

Sounds great, doesn't it? How's it done?

Here's a quick review of short-selling and using stock options called puts. Because of the risks and costs involved, these maneuvers aren't for everyone. Still, everyone should understand the basics in case a broker or other advisor suggests one of these strategies.

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Typically, you buy something such as a stock in hopes its price goes up. Pros call that going "long". The opposite is going short, or short-selling. Basically it means selling something such as a stock in hopes the price goes down.

You borrow the shares from your broker and sell them. If the share price falls, you could then buy an equal number of shares at the new, low price to repay the broker. So, if you sold shares of XYZ stock short at $10, then bought them back for $7 to repay the broker, you would make a $3-per-share profit. It's the same idea as any investment -- buy low, sell high -- but the order is reversed.

Why doesn't everyone do it?

First, there are expenses -- on top of ordinary trading commissions plus interest on the broker's loan. That's done in a margin account, using your other investments as collateral. The longer you hold the borrowed shares, the higher the interest cost -- a problem you don't have when you simply buy shares and hold them. These days, rates are around 5 or 6 percent.

The biggest shortcoming of short-selling is that your potential loss is unlimited. If you buy shares for $10 each, the most you can lose is $10 a share. But suppose you sold those XYZ shares short for $10 each and the price rose to $20. To pay off your loan, you could buy the shares at $20, losing $10 a share. Or you could wait. But if the price rose to $50, you'd lose $40 a share. At $100, you'd lose $90 a share. There's no limit.

To make matters worse, your broker could force you to buy shares at a high price to "cover" your debt. He'd issue a "margin call" when your debt, or potential loss, grew so large that your other investments do not provide enough collateral.

The other way to profit when prices fall is to buy "puts." These are stock options that give their owner the right to sell a given number of shares, usually 100, at a set price any time during a set period, usually a number of months. They are the opposite of "call" options that give the right to buy shares at a set price.

If you thought XYZ shares would fall from $10 to $7, you could buy an XYZ put, getting the right to sell 100 shares for $10 anytime in, say, the next three months. If the price fell to $7, you could buy the shares at that price and exercise your option to immediately sell them for $10, making $3 a share.

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With a put, you don't have to exercise your right to sell if you don't want to. If the share price rises instead of falling, you could just forget about the put. All you would lose would be the premium -- the fee you'd paid to buy the put -- plus the commission on the purchase. Options premiums fluctuate with market conditions but are always lower then the full price of buying real shares. You might, for example, pay $1 per share in premium, or $100 for a 100-share contract.

With puts, then, the most you can lose is your premium and commission.

On the other hand, with a put you face a deadline -- the option contract's expiration date. If you don't make money by then, you will lose what you spent on the contract. That cost can be considerable, especially if you buy puts repeatedly to continually insure your investments against loss.

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