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Mathew Ingram

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Go short

Mathew Ingram

TORONTO (GlobeinvestorGOLD)—So you've just come into a windfall. Maybe you inherited it from your great-aunt Ethel, who invented the Pez dispenser, or maybe you found a bag of money in a dumpster behind the bank—or maybe you finally got a settlement in your wrongful dismissal suit against Enron. In any case, you're relatively young and your regular investment portfolio, Registered Retirement Savings Plan, and so on are taken care of. What do you do with $200,000 that you can afford to lose?

Obviously, having a couple of hundred thousand dollars you can afford to part with doesn't mean you necessarily want to lose it. Presumably you'd like to invest in something fairly high risk—because you can tolerate it—but not something that is virtually guaranteed to fail. Otherwise, you might as well go to Las Vegas and bet it all on a spin of the roulette wheel, or invest in Fastbuck Resources on the over-the-counter stock market.

So you want risk, but also potentially high return, and something that has a chance of paying off. Here's one suggestion: short selling.

Short sellers borrow stock from someone—usually through a broker—and then sell it, hoping that the stock price will fall (in some cases, investors are allowed to short-sell "naked," that is without borrowing the stock). If the price falls, the seller can buy back the shares he or she borrowed at a lower price and repay the loan, pocketing the difference as profit. Many hedge funds, which tend to appeal to fairly sophisticated investors, use short selling as a way of boosting their potential returns.

Be forewarned, however: short selling can seem a lot easier than it actually is. For example, you may believe—as some analysts do—that Ontario-based handheld device maker Research In Motion Ltd. is wildly overvalued at its current price, which works out to about 100 times this year's estimated profit. So why not sell the shares short?

The biggest problem you face is that Research In Motion's share price has kept right on climbing for much of the past year—in fact, it has quadrupled. In addition, the stock is known for its volatility, since it occasionally jumps by as much as $10 in a day. That kind of thing can cause a short-seller a lot of pain, since a broker will "call in" a short if the stock goes up too much (this usually happens when an investor has shorted on "margin," meaning they only have a fraction of the underlying value of the trade in their account). Getting called means a short seller has to buy the stock at the higher price.

A short-seller's liability, in fact, is theoretically unlimited, since a stock can continue to climb in value forever, while a buyer's losses are limited by the fact that a stock can only fall to zero and no further. Most professional short-sellers use "limit orders" (built-in sell orders targeted at a certain price) and other methods to keep from getting squeezed by a sudden climb in value—but even that can sometimes be unsuccessful. If you are a small trader, for example, and a stock jumps by a huge amount in a short period, you may never get the chance to have your order filled at the price you set.

That kind of risk is why you should only engage in short sales with money you can afford to lose—which makes it perfect for you with your $200,000 stash. That said, short-selling can make you a substantial amount of money in a relatively short period of time, provided you bet the right way. Anyone who shorted Nortel Networks Corp. on its way down to the $2 level from about $90 could have made an awful lot of money—in fact, one investor bragged to a journalist that short-selling the stock once it got to the $30 level more than made up for all the money he lost by owning it while it was falling.

In a similar fashion, anyone who sold shares of Biovail Corp. short starting in June of this year—when analysts began raising concerns about the company's aggressive accounting methods, and the declining profitability of its products—would have made a handsome profit, since the shares have fallen to about $20 from the $60 range.

If you believe that the Nasdaq market index has got ahead of itself, as many do, you can short the Nasdaq 100 trust, also known to traders as the Qs, since the symbol for the trust is QQQ. That has the benefit of being heavily traded, which means a short seller is able to get in or out easily (one of the other risks with a short is not being able to find stock when you need to buy it, which leaves you sitting there helplessly until your order can be filled).

If you're looking for stocks to short, one way to find them is by scanning the business pages looking for stories about companies that have taken a bad turn: they're being investigated by the Securities and Exchange Commission, for example (as Biovail is), or they just came out with a quarterly loss that surprised the market. Of course, in some cases those are one-time events that the market quickly recovers from. Another strategy is to use a stock filtering method, like those available at GlobeinvestorGOLD, to sort through the Dow or the Nasdaq looking for stocks with unrealistically high price-to-earnings or price-to-sales ratios.

Just make sure to pick a liquid stock (that is, one with a fairly high trading volume) and use a limit order. You wouldn't want Aunt Ethel to think you were wasting her hard-earned money.

Mathew Ingram joined The Globe and Mail's online news team in June of 2000, after spending four years as the Western business columnist, based in Calgary.

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