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Dear Daily Crux reader,
After the market declines of the past two weeks, many investors are looking for ways to protect their portfolios and profit if stocks fall further. Naturally, many people are thinking about selling stocks short for the first time. If you're one of them, you don't want to miss this week's interview.
It's with our colleague Jeff Clark, editor of the S&A Short Report, and one of the most successful traders we know.
Jeff sat down with us to explain the basics you need to know before you short a single share, including the best stocks to short and how to dramatically reduce your risk.
Good investing,
Justin Brill
Managing Editor, The Daily Crux
www.thedailycrux.com
Monday, 15 August 2011
The Daily Crux Sunday Interview
The World's Greatest Investment Ideas:
Short Selling
The Daily Crux: Jeff, can you quickly define "short selling" for us?
Jeff Clark: Short selling is the attempt to profit off a decline in stock prices. You're basically selling something you don't own with the expectation you can buy it back later at a lower price.
So it's the opposite of buying low and selling high. With short selling, you sell high first, then buy low later on.
Crux: Many investors have never shorted stocks, because they believe it's too difficult or too risky. Why should investors add shorting to their investing skill set?
Clark: Successful investors take advantage of opportunities. It doesn't matter if those opportunities are in the stock market, the bond market, currencies, real estate, whatever. And it shouldn't matter whether those opportunities are on the upside or the downside.
Short selling is an important strategy for any portfolio. Stocks move up and down. If you're only investing on the up moves, you're only taking advantage of half the opportunities. Shorting is an ideal way to both hedge your portfolio and profit directly from declines in the market.
Crux: Can you briefly explain how to short a stock?
Clark: Technically, the process involves "borrowing" the stock from your brokerage firm (who borrows it from a customer, who owns the shares in a margin account).
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For example, if you wanted to short 100 shares of company ABC, you would ask your brokerage firm to borrow 100 shares. If the firm doesn't have any customers with company ABC's stock in a margin account, there wouldn't be any shares available to short and you would not be able to make the trade. If there are shares available, you could sell the shares short. The cash for the sale would then be credited to your account.
I'm going to keep the math basic here, but suppose each share of company ABC is currently trading for $20. Your account would be credited $2,000 for selling those 100 shares short and your position would appear in your account as negative 100 shares of company ABC.
When you decide to close – or "cover" – the position, you would go into the market and buy back 100 shares of company ABC. The negative share balance would be zeroed out, and the purchase price debited from your account.
If your bearish stance was right, and ABC declined 75% to $5 per share, your account would be debited $500... In other words, it would cost you $500 to buy those shares back.
Since it only cost you $5 per share to buy the shares back, you would pocket the difference... in this case $15 per share, or $1,500. That's how a profitable short sale works.
Crux: Are there particular types of stocks that are ideal to short?
Clark: There are three ideal short selling candidates...
First are "fraud" stocks – companies with fake products, deceptive financial statements, snake oil management, etc. These are the toughest to find, but they're usually the most successful short sales.
Look at what happened recently with the Chinese reverse merger companies. You had dozens of companies that took advantage of the hype of the "great China boom." They raised a bunch of money by selling stock to American investors. But the companies weren't viable businesses. Management fabricated the financial statements, announced deals and breakthroughs that never happened, and basically stole investors' money.
China Sky One Medical (CSKI) topped out in January 2010 around $24 per share. Today, it's down 90% from that level. Orient Paper (ONP) was $14 per share at the height of the China stock market popularity. ONP trades for just over $3 today. China Green Agriculture (CGA) is another good example. It was a $17 stock that trades for about $4.50 today.
Next are companies with flawed business plans. You don't have to look much further than the Internet craze of 2000 to find great examples of bad business plans. These companies didn't intentionally try to deceive investors. They were just never going to show a profit.
When analysts start talking about valuing a company on "page-views" or "eyeballs" or some other screwy method other than profits and earnings, you have to start considering the stock as a short sale candidate.
Commerce One (CMRC) was probably my most successful short sale back then. Anyone could look at the SEC filings for this business-to-business e-commerce company and figure out it was never, ever, going to turn a profit. The numbers simply didn't work out.
Yet, at the peak of the Internet bubble, CMRC was a several billion dollar company. I remember selling the stock short at something over $300 per share and then buying it back just a few months later for less than $20. Today, of course, CMRC is a penny stock.
The third ideal short candidates are overpriced stocks that have broken down technically. It's tough to profitably short stocks only on the basis of valuation. Expensive stocks have a habit of getting more expensive. And as the famous quote goes, "the market can remain irrational longer than you can remain solvent." So timing is important.
Netflix (NFLX) is a great example. Here's a stock that most folks agree is expensive. The stock trades at 61 times earnings and 38 times book value. Yet, NFLX is one of the best performing stocks in the market over the past few years. It's up more than 400% since early 2010.
You can't fight that sort of momentum. It's best to wait until the momentum dries up and the stock starts to trend lower before attempting to sell the stock short.
Crux: Are there strategies for timing a short sale more successfully?
Clark: Just as it's usually a bad idea to chase a stock's price higher when you're buying, it's also bad to sell short into a rapidly declining market. Stocks that are oversold tend to bounce, sometimes violently. The safest way to sell short is to wait for a stock's momentum to shift from bullish to bearish, especially for the third type of stocks I just mentioned.
One tell-tale sign the momentum has shifted is when the stock price drops below its 50-day moving average (or "DMA").
The 50-DMA is a commonly-watched technical level. Generally, when a stock is trading above its 50-DMA, the trend is bullish and traders can use pullbacks in the price to buy into the position. On the other hand, when a stock is trading below the 50-DMA, the trend is bearish and traders can sell short into any rally attempts back up toward the 50-DMA.
So the safest way to short is to look for that break below the 50-DMA... and then wait for the inevitable oversold bounce. If the stock can bounce back up and "kiss" its 50-DMA from below, it's a terrific risk/reward setup for a short trade. The 50-DMA should serve as resistance, and a stock with bearish momentum will have a tough time rallying above that level.
So you'd be shorting at an optimum resistance point and the stock should start trending lower almost immediately. If the stock can somehow rally above the line, it negates the bearish pattern and you can cover the trade for a small loss.
Crux: Besides waiting to use moving averages to initiate short positions, are there any other strategies you use to limit risk?
Clark: The best way to manage risk when shorting actually doesn't involve shorting at all.
Nowadays, going through the process of shorting a stock itself is largely unnecessary. Investors can achieve higher returns with less risk by buying put options or creating option combinations.
Anytime you buy an option, the most you can lose is the price you pay for that option – which is always much less than you would have at risk in the stock. It doesn't require borrowing the stock, and it almost always involves less capital up front.
So as long as you don't over-leverage the trade, you have a built-in risk management system with options.
The mistake a lot of novice traders make is they take on too large a position. Suppose an investor has the capital available to short sell 100 or 200 shares of a particular stock. In place of short selling those 100 or 200 shares, they'll often buy 10 or 20 put options.
Summary: When used correctly, short selling is a terrific strategy for any portfolio. It's an ideal way to both hedge your portfolio and profit directly from declines in the market. It can turn those normally difficult times in the market into profitable times.
Since each option contract represents 100 shares of stock, that's like shorting 1,000 or 2,000 shares of stock. It's a much larger position than they would ever take normally. But because options are so cheap relative to the stock, they feel comfortable taking on that sort of leverage, and end up risking much more money than they otherwise would. Inevitably, that excess leverage blows up and the trader suffers a huge loss.
So if you normally trade in 100 or 200 share lots, you should buy one or two put options instead of shorting the stock. If you trade in 1,000 share increments, 10 put options gives you the same coverage. Don't over-leverage the trade, and the risk will manage itself.
Crux: Is there anything else investors should know about shorting?
Clark: Perhaps the most exciting aspect of short selling is the speed at which profits can occur. Stocks tend to fall a lot faster than they rise. After all, you rarely hear of a "buying panic." So it's not uncommon to earn 30%-50% on a short trade in just a few weeks. If you trade put options, the returns can be considerably larger.
Crux: Thanks for your time, Jeff.
Clark: You're welcome.
Editor's Note: Earlier this week, Jeff sent S&A Short Report subscribers one of the most valuable pieces of trading advice we've ever seen. He laid out a roadmap for successfully trading the other side of this month's crash. If you're looking to profit from the short side now, you owe it to yourself to take a risk-free subscription to theS&A Short Report. You can get instant access by clicking here.
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