Short-Selling: An Investing Strategy for the Next Crash

After five years of booming stock markets, many investors are getting nervous about the possibility of a big pullback. Those who strongly believe that the market is overvalued can set themselves up to profit from falling stocks by selling those stocks short. Pick the right moments, and you can have great success betting against overpriced stocks, but it's important to understand going in all the risks and costs involved with short-selling.

How Short-Selling Works

Short-selling can sound complicated, but the process is actually pretty simple. In order to sell short, you borrow shares from someone who owns them and is willing to lend them to you. Once you have the shares, you sell them in the open market for the prevailing price, keeping the cash proceeds.

At that point, you're hoping the stock will fall in value. If it does, you can buy back the shares at a cheaper price, return them to the person you borrowed them from, and pocket remaining cash you have as profit. But if the stock prices rises after you sell it short, eventually, you still have to reacquire those shares to return them to their real owner. The extra amount you have to pay comes out of your own pocket and represents your loss.

The Costs of Short-Selling

Most investors assume that the costs of selling stock short are similar to ordinary share purchases. When you sell short, you generally pay the same amount in commissions that you would to buy shares. When you close out your short position, you'll pay another commission, %VIRTUAL-article-sponsoredlinks%just as someone who bought stock would when they decided to sell.

But with certain stocks, additional fees can apply. What you'll pay depends on how hard it is for your broker to find shares it can borrow on your behalf so that you can turn around and sell them short.

With large companies that trade millions of shares every day, any fees associated with locating shares to sell short will generally be minimal. But the smaller the company and the less trading activity there is in its stock, the harder it'll be for your broker to sell shares short. Stocks in which many bearish investors already have short positions can be even more difficult to borrow, which will lead some brokers to charge a borrowing fee.

Borrowing fees can make it a lot harder to make money by selling a stock short, because in many cases, you'll incur those fees for every day that you keep your short position open. That means that even if the stock price goes down, you might still not earn a profit after considering your out-of-pocket costs.

Covering Dividends

Many short-selling investors also forget that if the stock they've borrowed pays a dividend, they'll be responsible for paying that dividend to the person who let them borrow the stock. Often, share prices will drop immediately after a stock declares a dividend, giving short-sellers the chance to offset gains to counteract the negative impact of having to cover a dividend payment. But when you short high-yielding dividend stocks, it's essential to remember that you'll have ongoing cash drains on your account when dividends are due.

Short-selling can be extremely lucrative, especially in falling markets. But it's important to know all the potential risks and costs involved so that you don't get a nasty surprise.

You can follow Motley Fool contributor Dan Caplinger on Twitter @DanCaplinger or on Google Plus.