What You Need to Know Before You Short
Traditional portfolio allocation says to diversify with small caps, big caps, aggressive growth, domestic markets, foreign markets, emerging markets, income stocks, and so on. What’s missing from this is what I refer to as the “short side” — companies and market segments that are failing.
There are three things you need to do before you decide to short stocks.
1. Ask yourself what percentage of your portfolio you should allocate to shorting.
The funds you use for shorting stocks should be from your trading account and/or high-risk capital — and that means it lies somewhere between 0% and 100% of your capital.
2. Determine what part of your portfolio the capital you’ll use, to short stocks, will comes from.
To mitigate risk, individuals should short stocks through the purchase of puts options, rather than opening themselves up to the unlimited risk of shorting stocks outright. And although with the purchase of puts the most you can lose is what you put into the trade, you should only be using high-risk or trading funds.
3. Decide how much of your portfolio goes to each short-side trade.
This factor depends on the opportunity. But since my first rule is to play defense and the second is to wait for the great trade, it is best if each position is no more than 5% of the capital you have allocated for the short side, preferably less.
When Should You Short?
Now for the trickier part — when should you short a stock?
While each trader has their own preferences for going short or long, there are some rules of thumb that will help you get started and ultimately drive how you spot potential opportunities.
- Short when you see bad news coming for a specific company or market segment, regardless of your view of the overall market’s direction.
- Short when a great opportunity arises based on both the underlying fundamentals and a lack of favorable short-term technical indicators.
Setting Targets
When creating put positions, you are not in the game for a 10% pop over six months. You’re sights should be set much higher. You’re initial goal should be to hit a home run — i.e., a double. However, this entails taking on more risk.
Shorts can run away from you and puts can expire worthless, so you need to keep this risk/reward ratio in mind when shaping your commitment to short positions.
Here are a few guidelines that follow the words and practice of many great traders and investors:
1. The most money is made when you stick to your beliefs, even through tough times and volatility.
2. Play your hand hard when profits appear.
3. Be disciplined and patient; there is always another trade or investment.
When things are looking great, people go long a stock. When things look bad, they can go short. But there is no compelling reason to make any investment or trade if it is not a great one. There is always another opportunity. Always.
Play Defense First
The flip side of trying to hit home runs and waiting for great opportunities is the need to play defense and to be careful about how you allocate your risk capital to one position.
Many of you already have systems or rules in place — use them, do not change them because you are shorting a stock with a put option.
That being said, never put more than 5% of your high-risk or trading capital toward any one trade. You may want to overweight some positions, but you should never underweight a position — that usually means you’re uncertain and, therefore, should not be making that particular investment.
When it comes to limiting your risk, the 5% solution is not enough. You also need to be mindful of the links that may exist between your positions.
For example, if you have 10 positions in banks, any big, exogenous move — such as a government bailout — could temporarily hit all 10 positions, and they will trade as if they are one giant, over sized position.
There is nothing wrong with having more than one position in a market segment, but you need to make sure you are not accidentally overweight in one area due to correlations you may not have seen when you first created the position.
Also, keep capital in reserve to add to positions if they start to run.
Michael Shulman is the editor of ChangeWave Shorts, an options trading advisory newsletter, and is a contributor to the OptionsZone Web site.