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Selling Short, Walking Tall


Making the best of a bear situation.

Many investors, especially the little guy who has his money in a mutual fund, are tearing their hair out in the current downbeat market.

Not short sellers.

A sour market is duck soup for them.

Here's how short-selling works: An established investor with a solid record borrows shares from a broker and immediately sells them, hoping to buy them back later at a lower price. The difference between the selling price and the repurchase price is the short-seller's profit - if all goes well. But if the stock rises, the short-seller's squeezed and takes a loss when buying the shares back to return them to the broker by an agreed-upon date.

Short-selling isn't illegal, although it regularly evokes shrieks of horror from some members of Congress. The smart investor -- even an individual investor who doesn't use the tactic -- can benefit from it.

By checking the short interest on a stock, an investor can see how the smart money is playing it. Think of it as an early warning system: You may want to reconsider your long position in, say, General Motors (GM), Toll Brothers (TOL) or Washington Mutual (WM) if the pros are betting against the company.

Some short-sellers have cleaned up on recent troubles at Fannie Mae (FNM) and Freddie Mac (FRE). Both stocks traded at $60 or so last October but have been hammered by the continuing downturn in the housing sector, losing about 70% of their value. The shares fell again Friday.

On Thursday, U.S. Treasury Secretary Henry Paulson Jr. and Federal Reserve Chairman Ben Bernanke said regulators assured them that both Fannie and Freddie had enough cash and assets to weather current turbulence in the markets.

Some huff that those who start rumors to drive a stock down should be jailed. But that's a tough one to prove in court: No matter how scuzzy the rumor monger, the short-seller may honestly believe the impending bad news - and it's almost impossible to prove otherwise.

Individual investors shouldn't sell stocks short - it's an extremely risky blood sport. Leave that to the pros.

However, if mutual fund fees are taking a significant bite out of your diminished returns in a sour market, you can hold down costs with Exchange Traded Funds (ETFs). If ETFs have never been fully explained to you, here's what you need to know: They represent a basket of stocks and offer diversification few investors can match on their own.

ETFs aren't actively managed, which keeps costs low. Investors don't hold the shares directly. Instead, ETFs represent ownership shares in the fund that holds a portfolio of common stocks that track a market sector, index or mix of international stocks.

Remember: Extensive trading will drive up costs and erode returns, because most individual investors must buy an ETF through a broker.
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No positions in stocks mentioned.
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