Written by: Justin Daniel Lawlor

Typically, investors profit when a stock appreciates in price. But this is one of the biggest fears of the short seller. Selling shares of stock short is a fairly simple concept: investors attempt to profit as the price of a stock declines. It is the exact opposite of “going long,” or purchasing shares of common stock, in a given position. However, the steps taken in a short sale transaction are somewhat complex.

Before a trade may be placed, the investor must have a margin enabled account, which essentially allows for short-term borrowing from a brokerage firm. After receiving a client’s short sale trade order, a brokerage firm borrows shares of the stock, either from its proprietary account or from that of another client, and sells them in the open market.

As time passes (and the stock hopefully has fallen in value), the investor may decide to “cover” the short position by repurchasing shares and returning them to the broker. The investor’s profit is the difference in price between the proceeds of the initial borrowed sale and what was paid to cover the position. As I warned you, the logistics of the transaction are a little tricky to wrap your head around.

Short selling does provide numerous benefits to the financial marketplace. Probably the most important assistance that short sellers provide to the markets and other investors is the discovery of fraudulent practices and their resulting lofty valuations.

Enron, for example, exercised fraudulent and questionable accounting and reporting policies and short sellers served as the primary whistle blowers. The same is true of companies such as Lehman Brothers, Allied Capital, and the last decade’s Internet and real estate bubbles. Short selling is also critical for market liquidity and serves as an invaluable tool for money managers who wish to “hedge” against exposure and volatility.

There are many individuals who question the morality behind selling stocks short. After all, investors are betting on the downfall of a company. Some question whether profiting at the expense of a company and its stakeholders should even be legal. I personally believe that short sellers are critical for ensuring full financial disclosure and keeping stock valuations in check.

Furthermore, there are several other considerations to bear in mind before selling securities short. Historically, markets generally trend upwards. If for no reason other than inflation, stock prices tend to increase over long-term periods; thus, the odds are already set against the short seller. Also, there is a limited upside gain when selling stocks short, while the potential loss is theoretically unlimited. If an investor is short a given stock, it’s true that the price per share may fall to zero, what is referred to as a terminal short.

But the price per share could also continuously rise with the help of stock splits, which is obviously hazardous for the short seller. Short sellers are also required to pay interest on the shares that have been “borrowed” from the brokerage firm and must cover any dividends that the company has issued over the trade period.

All factors considered, short selling is an art that takes a keen eye, persistent attitude, and most of all, conviction in a thoroughly researched investment thesis.