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Short selling's ups and downs

If the markets are heading for tough times, some investors reason, why not try to make money on the way down?

Given the market's current weakness, some "long" investors may be wondering whether the time is right to start going "short." If the markets are heading for tough times, they reason, why not try to make money on the way down?

It may seem simple, but selling short is extremely risky and complex: Shorters can lose their entire initial investments and more. The technique, when successful, is complicated and time-intensive, requiring research, collateral, experience and luck. Even seasoned shorters often stumble.

"Shorting is something that the average investor shouldn't even think about," said Ronald Masulis, professor of finance at the Owen Graduate School of Management at Vanderbuilt University in Nashville. "If you shorted the Nasdaq, you wouldn't be a very happy person right about now. The potential downside risk is enormous. It's unlimited."

Shorting is investing in reverse--a way to profit from a declining stock. Instead of buying today and selling tomorrow, hoping the stock will increase, shorters sell today and buy tomorrow, hoping the stock will dive.

For example, a Charles Schwab customer might borrow 100 shares of a company that is trading at $80 and immediately sell the shares for $8,000. If the shares later fall to $40, the investor could purchase the 100 shares for $4,000 and return them to Charles Schwab, netting a profit of $4,000.

But brokers must first approve shorters to borrow shares on margin, and the broker may recall the shares at any time--usually when the price is much higher than when the shorter borrowed them. When that happens, the shorter must pay cash or put up collateral to compensate for the difference. In the above example, if the shares climbed to $120, Schwab might require that the customer repay the borrowed shares, resulting in a loss of $4,000.

In addition, shorters can only sell during an "uptick"--when the stock is on an upward climb--however slight. Loathed by shorters, the uptick rule makes the technique dangerous. If shorters aren't vigilant in checking prices and immediately acting at the uptick, they may not be able to execute a trade.

Because shorting requires so much diligence, traditional investors--the vast majority of individual investors and mutual fund managers in the United States--should not try it, experts said.

"Since 1800, the market has been up two years out of three. Why you would ever bet against that long term baffles me," said Richard Rogalski, professor of investments at Amos Tuck School of Business at Dartmouth College in Hanover, N.H., and former manager of a mutual fund with some short holdings.

"Short term, yeah, maybe it'll be down," Rogalski said. "But it's not a long-term phenomenon, and it's extremely tough. Shorters don't get much sleep at night."