Better Way to “Short” a Stock

In November, many investors were betting heavily that the price of Keurig Green Mountain stock would continue to plunge. Instead, the price soared by about 70% when an equity group agreed to acquire Keurig. That meant huge losses for many investors who “sold the stock short,” meaning they had bet the price would drop.

As of November 30, the total number of shares of all stocks held short on the New York Stock Exchange had risen to a near-record 17.5 billion. How it works: When you short a particular stock, your brokerage firm actually lends you shares and you sell those shares on the open market. Then, assuming that the price drops, you cover the position by buying back an equal number of shares to return to the brokerage firm. The difference in price results in a profit for you.

The dangers: When you buy a stock, the most you can lose is 100% of your investment if, say, the company goes bankrupt. In contrast, when you short a stock, there’s no cap on how much money you might lose if the price soars. Also, if many investors have shorted a stock and begin to panic, their rush to buy back shares could accelerate gains in the price, causing you to suffer steeper losses. And if the price is rising, the brokerage might force you to exit your position early or add money to your account to cover potential losses.

My advice: Never short stocks—it’s always too dangerous. But if you are determined to bet against a stock, consider a put option instead. This gives you the right but not the obligation to sell the stock at a specific price by a specified expiration date. You obtain this right by paying a premium, the size of which depends in part on how far in the future the expiration date is. That way you can’t lose more than your premium.