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Tips for Selling Short Against the Box

Selling short against the box is a very tempting yet a very tricky, and involving investing method. Often times, only the most experienced investors will be successful with a short sale. This technique is where an investor sells a security before they own it. Here's how it works: an investor borrows shares from their broker then immediately sells the stock. The investor is hoping that everyone will catch on to what seems to be a flaw in the market for that stock, then sells the stock which in turn sends the stock price downward. When the stock price has dropped far enough, the investor that borrowed the stock initially will buy enough shares to repay the broker back, keeping the difference between the price at which the investor borrowed the stock from the broker and the price at which the investor bought shares in the open market.

An Example:
Boeing stock is selling for $38, and you think this price is going to fall drastically; you do not own any Boeing stock at this point. You decide to borrow 100 shares of Boeing stock from another client of your broker's who does own the stock. Then you sell the shares at the current price of $38. Unfortunately for other shareholders, Boeing's stock price falls to $20 and you decide to buy 100 shares at the current market price then give the borrowed shares back to your broker's client. Now you've made $18 per share of Boeing stock. You're probably familiar with the phrase buy low sell high...well in this case the idea is to sell high first, then buy low.

This sounds, initially, like a perfect plan, however, it often has the exact reverse effect than is initially intended. Many investors seem to "zero in on" the up side potential or the profit of this plan and seem to forget the possible horrific implications that could result. If you bet in the wrong direction and prices end up rising drastically, you could possibly end up owing more than your initial investment. The worst part is that there is not clear definition for how high the stock prices could go (it's unlimited).

When you buy a stock and own part of the company, in traditional sense, you are going to share in the growth of that company. The most you could possibly lose is your initial investment and no more. The most you could gain is virtually limitless. But when you sell short against the box the most you could lose is limitless. Your potential loss is limitless because there is no limit to how high a stock price can rise. Many investors find themselves losing 200, even 300% of their initial investment- they end up owing a debt.

With all of the possibly negative implications of selling short against the box, there is absolutely nothing wrong with it. Barron's actually considers selling short to be a legitimate investing technique and they also include in their money manager interviews a short sale recommendations section. However, a word of caution is due: it's extremely high risk. This is by far, an investment technique only meant for the professional traders with many years of wisdom and market "pizzaz", and often times not even meant for them.

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