4 Rules for Successful Short Selling

Savvy short-side investors make big, quick profits from falling stocks in good times and bad markets.

Whether you’re shorting a stock the traditional way, or doing it the smart way – i.e., buying put options – choosing a name to play to the downside should be just as well thought out as any long side play that you add to your portfolio.

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But how do you go about finding spectacular short side plays and, more importantly, profiting from them? I have four solid rules that shed some light on how to survive and thrive on the “dark side.”

Rule No. 1: Take a short position based on fundamentals as though it were a long term position.

I am a stock-picker at heart, meaning I study companies’ business models, management, product lines and prospects instead of looking at just their charts.

There are a lot of technical gurus out there who use past stock performance as prelude to where a stock “should” trade next. But just because a company appears to be doing OK does not mean that it can keep up its past performance, especially if it’s starting to crumble from the inside.

Wall Street seems to want to believe the best in companies, and its pundits often pooh-pooh less-than-stellar stock performance as temporary. My tried-and-true method of making money on the short side is to get situated while everyone else is rooting for a company’s recovery.

I’m not a day trader looking for a quick 3% to 5% gain and heading for the hills whether or not I get it. Rather, I do comprehensive analysis and put my money on the bets that stand the greatest chances of paying off… and paying off big.

Don’t get sucked into “trade-only” plays. Even if a chart is lousy and a trade looks good, you should never go against fundamentals. Sure, you may miss something here or there, but the discipline you exercise with your long side investments is also vital on the short side.

In the same vein, you may be tempted to head for the hills at the first sign of good news for a shorted stock. But if you based your trade on crumbling fundamentals, you must tell yourself that “this, too, shall pass” when you see a bad stock caught in a temporary updraft. Sticking to fundamentals gives us confidence in the logic of a position and enables us to wait out market volatility.

Rule No. 2: Look for reasonably priced puts.

Just like stocks, options come in all shapes, sizes and prices. If you’re going to be trading put options, why not take advantage of the inexpensive but tremendous leverage that they offer?

Remember that one put option contract represents 100 shares of the underlying stock, and that option prices are quoted per share. So, if you see an option trading at $3, your investment would be $300 for a contract.

If that stock heads off a cliff and your put shoots up in value to $6, that’s a sweet money-doubler. But if you buy an option at $2 and it goes up to $6, you’ve effectively tripled your money. And if you’re going to go for gains, why not go for the biggest ones possible?

If a $4 put only goes to $5, it’s a gain, of course. But if you’re only in the market for 25% gains, you may be better off sticking with stocks. I have avoided some short side positions because the premiums on the puts were simply too expensive – and, therefore, the risk/reward ratio was unfavorable.

The lower the put entry price, the more money you can make when it turns in your favor. Accordingly, if things don’t go your way, then that’s less money you’ve put at risk.

Rule No. 3: Look for a perfect storm.

There are many reasons to short a stock. If you wouldn’t be caught dead owning the shares, that’s a pretty good indicator that it belongs in your short-side portfolio. But how do you go about picking the biggest losers? Like the saying goes, “It’s what’s on the inside that counts.”

If a company, stock or sector is ugly on the inside, it’s only a matter of time before the ugliness – e.g., broken business models, less-than-spectacular corporate leadership, loss of a competitive edge, etc. – shows on the outside. And then the stock goes down.

Finding a company that has been hit by sector weakness is a great way to play the short side. It’s even better if the stock you are looking at is also a poorly managed company, which means that even if the company recognizes its flaws, it couldn’t execute a turnaround in its business model within a reasonable time frame. If the company you’re shorting meets both of these conditions, then you’ve found a good trade.

Rule No. 4: Close and/or roll winning positions.

Even if a stock continues to slide, I urge you to close a big win and then open another position with more leverage utilizing only your original investment dollars. This is called “rolling” a position. It gives you the opportunity to raise some capital by closing a profitable position and “rolling” the original investment dollars into puts with a lower strike price and/or later expiration date.

Another reason you may want to roll your options position is because options come with an expiration date. And you may need more time to ride a stock’s slide as far as it can go. For example, it could take a year or two for the bad news to fully play out of a stock, but you may only have nine months with your put option position.

So, whether you have a winner and need to preserve your profits, or if time is running out and you haven’t yet gotten the results you expected, you can always buy more time to let the position play out. Rolling a position is similar to staying in a stock for as long as you want to be in it, but with a little more active management and attention.

And if just a little more work can yield a lot more profit, I can’t think of a better reason why you can’t afford to NOT be investing on the short side!

Michael Shulman is the editor of ChangeWave Shorts, an options trading advisory newsletter, and is a contributor to the OptionsZone Web site.