Every Wednesday, we publish our “Investor Toolkit” series on TSI Network. Whether you’re a new or experienced investor, these weekly updates are designed to give you specific investment advice. Each Investor Toolkit update gives you a fundamental piece of investing strategy, and shows you how you can put it into practice right away.

Today’s tip: “What you must know about short selling stocks”

Attractive opportunities for short selling come along from time to time, but it’s a hard way to make money. That’s because short sellers face a number of unique disadvantages that don’t apply to buyers.

The basics of short selling stocks

When you sell short, you borrow stock from a broker and then sell it. However, you eventually have to buy back the stock on the market to return it to its owner.

If the stock falls in price while you are “short,” you can buy it back at a lower price. You have then made a profit. But if the stock rises in price, you must buy it back at a higher price than you sold it, and you lose money.

Here are 3 important factors to be keep in mind when short selling:

1. Short sellers face an unlimited potential for loss: The main risk you face when short selling is that the returns are upside down. That is, when you sell short, your maximum gain is 100% (if the stock you’ve shorted goes to zero). But your potential losses are limitless. That’s the opposite of a regular stock purchase, where your gains are theoretically unlimited, and the most you can lose is 100%. You also have to pay for any dividends declared by stocks in which you have a short position.

How Successful Investors Get RICH Learn everything you need to know in 'The Canadian Guide on How to Invest in Stocks Successfully' for FREE from The Successful Investor. How to Invest In Stocks Guide: Find 10 factors that make your investments safer and stronger.  I consent to receiving information from The Successful Investor via email. I understand I can unsubscribe from these updates at any time.

2. Short-sellers don’t earn any income: Instead, they have to make good on dividends that the stock’s owner would receive. Right now, the average yield on the S&P/TSX Composite Index is 2.45%. So, on average, today’s short-sellers miss out on a 2.45% yield, and have to pay out that much to the stock’s owners, for an average disadvantage (compared to buying the stock) of 4.9% a year.
3. Today’s market is not ideal for short selling stocks: If you’re interested in selling short, the best time to do it is when the market has been booming and investors are confident and have profits to invest. That’s when you find lots of stocks trading way above any reasonable estimate of value. But today, many stocks are still attractive, based on any reasonable assessment of their value. So it’s an especially bad time for short selling.

Our investment advice: You may want to indulge in short selling stocks from time to time, but we advise against doing so as a habit, mainly because of the increased risks of short selling over regular stock purchases. That’s why you should only take part in short selling with money you can afford to lose.

Stick with our aggressive picks instead of short selling stocks

If you want to give yourself the potential for large, quick gains, you are far better off to avoid short selling and instead buy the aggressive stocks we recommend in our Stock Pickers Digest newsletter.

The latest issue gives you our full analysis, including clear buy/sell/hold advice, on 20 stocks that may be suitable for the part of your portfolio you devote to aggressive investing.

Best of all, you can get this issue FREE when you take a 1-month FREE trial to Stock Pickers Digest. Your 1-month trial also comes with 5 in-depth investment reports, our weekly Email/Telephone Hotlines and much more. Don’t wait! Click here to get started right away.

Next Wednesday, June 1 2011, Investor Toolkit will look at how to interpret “investor rules.”