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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Shorting Stocks: How to Find the Perfect Candidate for Profits

Most investors understand the need to keep a portfolio from becoming too risky. As we saw in 2008, those investors that were fully invested in the stock market took a terrible beating. That's why an increasing number of investors are now “going short,” finding a few stocks that appear overvalued to help balance out the collection of owned "longs" that appear undervalued.

How Short Selling Works

A short sale is a three-step trading strategy that seeks to capitalize on an anticipated decline in the price of a security.

1) Arrangements are made to borrow shares of the security, typically from a broker.

2) The broker gives the investor the shares and the investor immediately sells the shares in the open market with the intention of buying them back at some point in the future.

3) To complete the cycle, at a later date the investor will repurchase the shares (hopefully at a lower price) and will return them to the lender.

4) The investor pockets the difference if the share price falls, but takes a loss if it rises.

In a nutshell, by shorting a stock, you are technically borrowing shares in hopes of returning them once they have fallen in value. Your broker actually does the legwork, so it's as easy as specifying that you're seeking to invest a certain amount of shares "short" when you fill out an order.

Remember that you need to sign some forms with your broker acknowledging the risks associated with shorting. And retirement plans are forbidden from letting clients go short.

Short-selling surely entails risk. If you long a $10 stock and it falls to zero, you've lost 100% of your investment. But if you short a $10 stock and it goes to $30, you've lost 200% of your investment. That's why it's crucial to keep a close eye on your short investments. Many short-sellers choose to cover their position should a stock start to rise by purchasing shares, even though their price may not have fallen since he sold the original shares. 

When to Go Short

Short investing is far more profitable in a period of flat or declining stock markets -- many short-sellers stay on the sidelines while markets are in rally mode.

There are two main reasons to go short. First, that you've found a stock that looks certifiably overvalued and you predict a plunge ahead. Second, because the broader market feels increasingly risky and you're nervous that a pullback may be in the works. The stock market made major gains in the final trimester of 2010, so heading into 2011, an increasing number of investors are looking to protect their portfolios from pullbacks with a few shorts.

If you're in the latter camp, you may simply want to buy an exchange-traded fund (ETF) that makes a negative bet on indices like the S&P 500. For example, the ProShares UltraShort S&P500 (NYSE: SDS) moves at twice the rate in the opposite direction of the S&P 500. You can also invest short in other industry or sector-specific ETFs. For example, for those that believe gold prices will fall in coming quarters, you can short the SPDR Gold Trust (NYSE: GLD).

What about individual stocks? StreetAuthority often uncovers overvalued stocks and can help explain why certain stocks look headed for a fall. In the article Don't Get Caught Holding These 3 Well-Known Stocks, I found that share prices at each of these three companies appeared to reflect future forecasts that are far too optimistic.

Indeed, that's the most logical reason to short a stock; investors often get carried away with enthusiasm when a company is in the middle of a hot streak; they mistakenly assume the good times will last indefinitely.

Other red flags that should be of note to investors:

Analysts forecasts that fail to incorporate road blocks ahead. In the example of Netflix (Nasdaq: NFLX) in the story above, analysts expect sales and profits to rise more than 30% in 2011 simply because the company has been growing at that rate in recent quarters. But industry news tells us that Hollywood is pushing back hard and future movie distribution deals are likely to be far less profitable. That means Netflix will have to raise prices (possibly scaring away customers) or take a big hit to profits.

Debts coming due. A favorite item for short-sellers is the balance sheet. As you consider a company's liabilities, take note of the item entitled "current portion of long-term debt." These are the loans that will need to be paid back within the next 12 months.

For many companies, that means either new stock will need to be issued (and investors hate to hear about stock dilution) or if they can't roll over those loans, then a cash crunch may be coming -- and that can really hammer a stock. Grocery chain Supervalu (NYSE: SVU) has to pay off a $400 million note in February 2011. The prospect that the company will struggle to raise funds has pressured shares and attracted interest from short-sellers. (Conversely, if the company handles that debt burden without too much problem, shares could rally, creating headaches for short-sellers).

Shrinking profit margins. When an industry is growing at a rapid pace, all of the companies in the group are able to charge full prices for their goods and services. But when growth cools, companies try to steal market share from each other by cutting prices. Before long, everyone is cutting prices simply to retain existing customers. You can see this kind of price war in action by studying profit margins. If they have stopped growing and started to buckle, they may fall further in the periods ahead. Wall Street analysts are often too slow to spot this transition. If you see bullish profit growth forecasts in future periods even as profit growth is stalling now, you may be looking at a ripe short candidate.

Insider sales. As a stock rises in value, it's logical that an officer or director of a company would look to take profits and sell some shares. But if a whole cluster of insiders rush to sell at the same time, they're likely sending a signal that shares no longer look set for further upside.

Heavy concentrated insider selling is often a harbinger of bad news that appears a quarter or two later. Perhaps they think a major customer may soon be lost. Or they see that company costs are rising and profits will soon slump. It's even worse if those insiders are selling after a stock has taken a big hit -- a signal that more share price pressure is to come. You can look up insider buying and selling activity at a range of web sites including InsiderInsights.com and Yahoo Finance.

You can also look to short a certain stock as part of a "paired trade." For example, let's say you're bullish on the prospects for Acme Shipping and have bought its stock because it looks inexpensive by a variety of measures. Still, you're a bit concerned that broader economic forces may have a negative impact on business. To offset that risk, you can short the stock of one of Acme's rivals, preferably one that looks a lot more expensive in measures such as price to earnings, price to book value or price to cash flow. Using this long/short paired trade strategy, you've removed the macro risk from the equation.

Short-selling is a vital part of any winning long-term investment strategy. Stocks go down just as they go up, so why limit yourself to just half of the market action?