Dale Jackson

Personal Finance Columnist, Payback Time

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Isaac Newton, the father of physics and investing clichés, concluded that what goes up, must come down.

The average investor counts on more of the former and less of the latter by taking long positions, which brings us to another cliché: buy low, sell high.

But there is a way to make money on stocks that go down, and it’s called short selling. The strategy is complicated and risky, so only investors who understand and have enough long positions to cushion the blow should short. Working with an advisor is always preferable.

Here’s how short selling works:

• Shares are borrowed from a brokerage’s inventory, other clients or other brokerages. It’s important to remember they are borrowed by the short seller and not owned. Those shares become collateral. Interest and fees are based on the short seller’s relationship with the brokerage.
• Let’s say 500 shares are borrowed from the brokerage and the short seller sells them on the open market at $10 each. That $5,000 now becomes the collateral for the borrowed shares. The short seller can hang on to the cash waiting for the stock to fall unless the brokerage asks for the stocks to be returned, or covered. In the meantime, the short seller must pay the lender any dividends or rights.     
• When the short seller chooses, the shares are repurchased on the open market and returned to the brokerage. Let’s assume the price of those 500 shares fell to $7 each. The purchase price for the short seller is $3,500 – generating a gain of $1,500.

Of course, those shares could have gone up and bring the cost of replacing them above the original price.

Since there is no limit to how high a stock to go, there is no limit to how much a short seller can lose.     

Dale Jackson is BNN's Personal Investor. Follow him on Twitter @DaleJacksonPI