NEW YORK (CNN/Money) -
With so many stocks doing the lemming lately, it's been a fine time for short sellers.
Thursday it was Electronic Data Systems that took the dive, tumbling by half, after warning Wednesday that its results would come in well below Wall Street forecasts.
The computer services and outsourcing outfit had long been a target of shorts, who seek to profit by betting that shares will fall. The plummet in EDS adds to the coffers of short sellers already made plump by drops in Tyco, Enron, Worldcom and Global Crossing, to name a few.
But just because short selling has worked so well lately, that doesn't mean that individual investors should play along.
"Don't do this at home," said Jeff Matthews, a hedge fund manager at Ram Partners whose made money shorting both Enron and Tyco. "You need to know what you're doing and be on top of it every minute of every day."
To short a stock, an investor will borrow shares from a broker and then sell them (with the broker charging fees and expecting some collateral). If the stock falls, the investor will be able to buy the shares back, return them to the broker, and pocket the price difference. If the stock rises, however, the investor will need to buy the shares back at a higher price to make good on the loan.
So why's it so dangerous? Suppose you short a $10 stock. The most it can possibly go down, and the most you can possibly make going short, is $10. (And that's only in the rare case of the stock going to zero.) Your potential gains are capped. On the other hand, if the stock goes up, there's no limit to how much you can lose. If it hits $20, you're out $10; if it hits $30, you're out $20.
And the kicker is that often some of the best short-selling candidates do run higher before they fall. Tyco was a target of the shorts for years, but it wasn't until this year that the company's shaky foundation became apparent to the rest of the world.
Another problem with shorting: finding which companies to bet against is hard. You have to do a lot of homework, and you're not going to get much help from Wall Street.
Take EDS, for example. Until it warned Wednesday night, most analysts just loved the thing. Moreover, the Plano, Texas-based company had said back in August that it didn't expect US Airways bankruptcy "to be material to its results of operations or financial position." That guidance turned out to be wrong -- but you wouldn't have known it unless you were following the company very carefully.
"Shorting is very time intensive and it's very hard to do at home," said Bill Fleckenstein, the well-known short seller who runs Fleckenstein Capital. "That's not because you have to be smart, but because you have to have a lot of time devoted to it."
Fleckenstein noted that the best shorts tend to be counterintuitive -- usually you have to come to a conclusion that's opposite the prevailing view of most other investors. But the popular perception that the company is worth owning -- even if it's fundamentally flawed -- can send its stock sharply higher.
Conversely, by the time company management and Wall Street analysts are admitting that things are lousy, most if not all of the bad news is often in the price of the stock. Short sellers have to manage their positions very carefully if they want to make any money.
"Shorting," said Fleckenstein, "is a very easy way to have your lungs ripped out in a very short space of time."
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