Understand the potential risks of short selling a stock

While brokers are able to handle most short selling requests, shorting a stock is more complicated than going long or buying options. In fact, there are some major issues involved with short selling that you must understand before you attempt it. So don't even think about short selling before you've read this.

#1 Risk

In a long position, the most you can lose is 150% if you borrowed on margin to leverage your investment. With a short position involving the borrowing of the stock, your theoretical potential loss is unlimited.

If you borrow a stock when it is trading at $10 and the stock runs up to $200, then you're out $190 a share -- 19 times your original investment! Not a good thing.

#2 Finding the Stock

You may want to short a stock that is hard to find. The process of finding shares is called a "locate." If your broker cannot find them, then you cannot short the stock.

Some stocks are hard to short because their shares are not easily available to borrow, which could happen for a variety of reasons. If you are finding it hard to locate the shares to conduct the transaction, it likely means that the stock is not held by a large number of individual shareholders (more on this in #3) or that there is a large short position in the stock already (more on this in #4). It is also virtually impossible to short a stock with a price under $5, and you cannot short a stock within a specified period from its IPO, depending on the exchange the stock trades on.

#3 Liquidity

You should not short a stock that is not highly liquid, i.e., there are many millions of shares outstanding.

Without liquidity, you can be right and wrong at the same time -- right about the stock going down but stuck in such a way that you cannot quickly liquidate your short position and get the profits you deserve. Liquidity should be a prime consideration when establishing short-side positions.

#4 Outstanding Short Position

This is the number of shares of a company held short, measured in absolute numbers, or as a percentage of the float of the stock.

If this position is large, more than 10% to 20% of a company's shares, the word is out and the bad news is already incorporated in the stock price. For the most part, I avoid stocks with large short positions, and so should you.

#5 Margin Account

You need to open a margin account to short a stock. It is in this account that the funds from your sale of borrowed stock will be placed.

But don't count on collecting interest on this money. Not only will your broker charge you on the borrowed shares at the broker loan rate based on the price of the stock when you borrowed it (unless you are Warren Buffett or the CEO's cousin), they will not pay you interest on the funds in the account or sweep it into a money market fund.

#6 Margin Calls

And if a stock you have shorted moves the wrong way (up), you are going to need cash to meet margin calls -- perhaps daily. Your broker will ask you to put more funds in your margin account, typically enough to cover the purchase of the stock on the open market at the current price.

If you don't make the payment asked for by your broker and you have other securities held long in that margin account, your broker will sell those securities to meet the margin call.

#7 Early Sale

If the original owner decides to sell the stock, you must replace it -- either by finding other shares through your broker or buying it on the open market.

#8 The Short-Squeeze

You have probably heard this term more often than you care to remember. A short squeeze is a market event when the price of a stock rises quickly, prompting shorts to "cover" -- which means they must buy the stock in the open market to repay the shares they have borrowed.

This generates higher prices, which, in turn, prompts more people to sell and take a profit, which leads to brokers calling more loans, which then forces many short-sellers to go into the open market to cover their loans, and so on. Short squeezes can be ferocious, can last quite a while and can be very expensive.

#9 How to Cover

Believe it or not, you can end up owning a stock and shorting it at the same time if you are not careful with your instructions to your broker. When you call or go online to cover a short position, you must specify that this purchase is to cover the open short position. If you do not, you could end up buying the shares and have them sit in your account while also having an open short position on them.

Because short-sellers might find themselves exiting their positions in a hurry, it's important to take the time to ensure that you issue clear instructions to your broker so that you get out when you want to.

#10 Dividends and Taxes

If you have borrowed and shorted a dividend-paying stock, you will receive the dividends, but you, in turn, must pay the original owner the value of those dividends.

Also, should you hold a short position for more than one year, well, tough luck -- the IRS still treats capital gains as short-term gains. Ah, Uncle Sam is always reliable!