Often you hear the terms "going long" and "going short" with reference to taking a position in the market. Going long is a simple buy, when you buy a stock, derivative or futures contract in the traditional way, you are long on that trade.

Short selling is when you sell a stock, futures contract or derivative even when you don't already own it. You then have a negative holding balance, and some time you are going to have to buy the stock back to close your holding. You make a profit if the stock has fallen in price.

Short selling is easy to do on the futures market, and is considered to be completely routine and conventional. Short selling stock is harder to do, at least on the Australian market, because of various rules regulating the practice. It can be done, but must be reported by the broker to the exchange and is messy for a broker who usually has to borrow share certificates off a long term holder of the stock who has bought on margin.

A full service stock broker might do it for you if you are a valued client, but most discount stock brokers won't. Some types of derivatives such as exchange traded options and LEPOs can be short sold, but not warrants. You will need a margin lending account to participate in short selling.

The mechanics of short selling

To sell a share short, you must borrow the documentation of share ownership (otherwise known as scrip) from someone that actually does own the shares. The identification codes of the shares in question are needed so that the person (whoever it is, somewhere out there in marketland) can receive the shares that they are buying and receive their entitlements, annual reports, invites to the AGM, dividends and other bonuses. You are required to deliver the scrip to SEATS within five business days (as of 1997, last time I checked, now that we are on T+3 settlement perhaps it is now 3 business days).

You get this scrip either by borrowing the scrip from someone you know, or by dealing with one of the many organisations that are in the businesses of lending securities, including some brokers, custodian service divisions of major banks, some insurance companies and some overseas banks. If you use the professional service you will probably be charged a fee of one or two percent of the value of the short. Companies that lend scrip do this for the extra income, much as other share holders take a bit of extra pocket money writing covered calls. (See the options FAQ for the definition of a covered call).

You can only short sell certain stocks, there is a list of stocks which can be short sold published by the ASX, there are over 120 companies in that list. To fulfill legal requirements you must inform your broker that you are selling short, the broker then registers the short transaction on SEATS and accepts on your behalf a margin deposit not less than 20% of the contract price of the transaction, the margin is usually cash but you can also tender securities as your margin deposit. Some brokers ask for more than 20% deposit. This money is held in trust until you close out of the transaction by buying the shares (known as covering the short), and returning the scrip to the lender.

There is also a rule that you cannot sell on a downtick. If the bid/ask for a stock is $1.00 to buy, $1.05 to sell, you can't offer your short to the buyer at $1.00, you must join the queue above $1.05. The idea is to stop short sellers from engineering crashes in particular stocks.

Due to tax considerations all short sale transactions must be closed within 12 months, though there is nothing to stop you from closing the first short position and immediately going short again, just don't hold any short sale transactions open for 12 months or more.

The margin deposit is needed because of the chance of virtually unlimited losses if the share price rises by a large amount. There is no theoretical upside on share prices, but a short sale can only make as much as 100% of the value of the stocks, they can't fall below zero. If a share more than doubles in value you can lose far more than 100% of the contract value.

Should you short sell?

I am often asked why I wouldn't necessarily short sell a stock I consider to be overvalued. One person challenged me on this, if I'm such a confident value investor and believe in my methods then why am I not necessarily so keen to short sell? Does a hesitance indicate that I lack faith in my method?

As Buffett has famously stated, the difference between investment and baseball is that you don't get strikes called against you if you refuse to take a swing at perfectly good opportunities. You can stand there all day and refuse to swing if you want to, waiting until the type of opportunity you really want comes along. Short selling is one opportunity that many value investors choose to give a miss, here is why:

• losses are potentially unlimited, and you may get margin calls

• shorting isn't very tax efficient, you need to close out at the end of 12 months which means you are denied being taxed at concessional CGT rates

When a stock is overvalued, then it is a risky buy, but not necessarily a safe short sale. Sometimes it is more prudent to walk away from an opportunity rather than be forced to make a decision either way (for this reason, I have no view on the majority of stocks. I'm always looking for undervalued stocks to buy, but have no comment at all on most issues.)

The first point I made about losses being potentially unlimited is one of the reasons why sometimes it is best not to have a view on a stock, as opposed to being gung-ho about short selling.

When you buy a stock in the standard way you may lose your entire investment, but that is all. Buy 100 shares at $20 a share and you could lose $2,000. Short sell 100 shares at $20 a share then the most you could make would be $2,000, but if that stock promptly went to $50 you would lose $3,000.

If you are deciding to go short on some crazy speculative stock with a price earnings ratio of 50 you could just as easily see it go even higher to 250, giving you a loss four times what you could potentially have made if the stock had fallen to zero (bubbles are like that, sometimes).

Add to this the fact that to short sell a stock you need to go via a broker's margin account, so you might end up receiving a margin call. There is nothing intrinsically wrong about margin calls, except that they can come a very short notice and if the margin lender doesn't get your payment quickly they will exit your position at a loss. This is particularly annoying if the market subsequently moves in the direction you were anticipating it to, except you are already out and showing a loss because you weren't able to get to a bank in time to arrange the necessary money transfer since you only had a few hours notice.

Margin calls are a pain because they force you to focus on relatively unpredictable short term market movements, as opposed to long term fundamental valuations. Value investors can't predict what the market is going to do this week or next week, they know that their methods work best with a time frame between 2 and 5 years, which is often the length of time it takes for a genuinely undervalued stock to become fully recognised by the market and for fair value to reassert itself.

Perhaps you might want to hold off your short selling until the stock has a bit of downward momentum behind it, which is of course an area more frequently considered by people with a penchant for chart reading. Now there isn't necessarily anything wrong with that, but it isn't how I prefer to play the game, and that is why I am not a frequent short seller. If you decide that short selling is something you want to get into, then go for it, but it isn't a strategy for everyone.