Short sellers lose when the price of a stock they’re shorting rises.

— Roger Conrad, Big Yield Hunting

Alternately maligned and praised, short-sellers often rise to prominence at the height of economic and financial crises—when the bubble bursts and stocks pull back dramatically. In the most recent crisis, the portfolios run by John Paulson’s massive Paulson & Company hedge fund reaped an estimated $15 billion in profits, in part by shorting suspect mortgage-backed securities and shares of the now-absorbed Wachovia and Washington Mutual.

Paulson’s example serves as an inspiration to some investors—turning a profit when the market implodes is an impressive feat. But some commentators questioned the ethics of his triumphant bets against the mortgage finance industry.

Meanwhile, in testimony before Congress, both Richard Fuld, the former CEO of Lehman Brothers, and Alan Schwartz, the former head of Bear Stearns, maligned short-sellers and rumormongers for drying up liquidity and driving their companies into insolvency. In their opinion, the blame rested not with shortsighted business plans.

The Securities and Exchange Commission in September 2008 also temporarily banned short sales on 799 financial stocks to preserve the remnants of the tattered financial system and combat market manipulation. In early April 2011, market watchdogs in France, Italy and Spain imposed a short-term ban on short selling to quell the panic surrounding the EU’s ongoing sovereign-debt crisis and its implications for the Continent’s largest banks.

At the same time, short sellers inject additional liquidity into securities markets and can improve the market’s efficiency as a pricing mechanism by calling attention to overvalued issues. James Chanos, another well-known short-seller who founded hedge-fund operator Kynikos Associates, is often credited with calling attention to the fraud at Enron with his ostensibly contrarian bets.

For individual investors, these ethical and philosophical questions are less important than understanding how short-selling works and the best way to add short exposure to your portfolio.

Selling Stocks Short

Short-selling involves borrowing shares of a company and selling them immediately with the hope of buying the same securities back for a cheaper price at a later date. In a successful short sale, the investor pockets the difference between the initial sale price and the future sale price. For example, an investor who sold shares of solar module producer First Solar (NasdaqGS: FSLR) short at the beginning of 2010 would have reaped a roughly 25 percent gain through Sept. 1, 2011.

To sell a stock short, you must have an account that enables you to trade on margin, or borrow money from your broker. When you elect to sell a stock short, your broker lends you shares from its holdings or arranges with another broker or investor to lend you shares. The proceeds from the initial sale will be credited to your account. When you decide to “cover” your short, you’ll collect your winnings–minus any fees or dividends paid out–or swallow your losses if the trade doesn’t go your way.

Although speculative short-sales garner the most attention in the financial media, the majority of individual investors use short strategies to mitigate downside risk in their portfolio.

For example, you might offset your long bets on a sector with a mixed outlook by selling the group’s weakest names short. By correctly identifying the winners and losers within a particular sector, you profit from both long and short positions. On the other hand, if the entire sector tanks, you lose less money than if you had only made long bets.

In other cases, investors might bet against a sector that faces significant headwinds while going long one or two names that offer some upside. A host of exchange-traded funds allow you to short a specific industry or sector with one security. At the height of the credit crisis, you could have purchased ProShares UltraShort Financials (NYSE: SKF) to profit from the financial sector’s woes.  

But short-selling also involves some unique risks of which investors should be aware. For one, the upside potential is limited relative to a long bet. A stock can’t decline below zero, but in theory there’s no ceiling on stock prices.

Moreover, an overvalued stock can continue to run up in a bull market far longer than you may be able to stay solvent. Timing is of the essence when it comes to shorting individual stocks; individual investors run the risk that the rising tide of positive news flow will lift all ships, even the worm-ridden ones.

Margin Calls and Short Squeezes Are Risks

When a short sale isn’t working out in your favor–i.e., the stock has appreciated in value–you may be subject to a margin call as paper losses mount. In this situation, your broker will require you to deposit more cash in your account or sell some of your other positions to meet minimum collateral requirements. As Roger Conrad, co-editor of Big Yield Hunting, recently wrote:

Those who sell short too aggressively will be forced to liquidate positions quickly or risk being wiped out. Failure to do so in a timely way is why most people lose money when they short stocks and why litigation-wary brokerages generally restrict who they allow to sell short.

You should also steer clear of betting against a stock that has already attracted substantial amounts of short interest, lest you get caught up in a “short squeeze.” When a stock appreciates to a level that makes short-sellers uneasy, a spate of short covering can send the stock price soaring amid a sudden buying frenzy. Investors can lose a lot of money rapidly when a short squeeze occurs.

Although we tend to steer clear of speculative short plays, adding some short exposure to a long-only portfolio can provide welcome peace of mind in a volatile market.