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Rules of Thumb for Shorting Stocks

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...short selling looks a whole lot more fun than it actually is.

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Hi Fil -

I've got a question about how to play a falling stock. The last month has seen me miss two great opportunities. The first was the ever popular New Century Financial. I was negative on the stock since last fall, in the 30s, and made some money then, but missed the meat of the move, obviously. After the initial announcement, there was still plenty of money to be made, as the stock fell through the 20s, ultimately to a buck and change. However, I was scared to enter a new position, given the potential for a volatile snapback (even though I thought there was plenty more downside to come).

Last week, another stock I've been following and negative on, Technical Olympic (TOA), started to tank. If I had a nickel for every time I've thought of getting short the stock in the last week, I'd have almost as much money as if I had actually shorted the stock! Unfortunately, again, I've been afraid to enter a position, when the stock has already fallen 15% (only to see it fall another 10%, and then another 8%, and then another 13%). So, my question is if there are any "safe," or more appropriately, defined risk ways to play a falling knife. Because defining my risk has been where/why I couldn't pull the trigger. Any ideas?

Thanks!
Minyan Steve

Welcome to my world Steve!

Take my word for it, short selling looks a whole lot more fun than it actually is. It doesn't just tax your pocket when things go against you, it messes with your head and makes you lose focus of what's actually happening. Nevertheless, with the added caveat that I would never describe myself as a "dedicated shortseller," I will lay out some of the rules I try to follow when taking shots at the "dark side."

  • Never short "valuation" alone – as skewed as valuations can get because of momentum players, media hype, rumors, etc., if there is a good story behind the stock, valuation will not hold back its price.

  • Once you have identified the "bad story" behind your stock, you also must have some way to determine when the bad story will unfold. The sub-prime guys are Exhibit A for why this is so true. Anyone who cared not to be in denial knew two years ago that New Century and company would end up the way it has. The numbers stopped adding up years ago, and the mania was obvious to all but the maniacs. And yet it would have cost you 30%-40%-50% in dividends, and probably 3%-5% in borrow premium to stay short for all that time. And as is the case with most bubbles, there was no magic reason for the unwinding to happen when it did. The orgy could have easily gone on another year.

  • As a corollary, set a time limit for your downside catalyst, and if it does not play out by then, move on. Sticking around will only cost you opportunities and mental aggravation.

  • Consider the macro backdrop: when anything can be used as collateral, and people are stomping all over each other to lend money, it is probably not a good idea to short individual companies. It does not matter how crappy a company might be, if "Other People's Money" is available, the risks that someone will use it for LBO's or buy-outs are not worth taking. Waking up short Biosite (BSTE) can ruin your day (and week... and year).

  • Know who are the large shareholders and ask yourself if you want to pick a fight with them. A mutual fund with a large stake is probably going to turn into a seller if the stock heads the wrong way. An activist hedge fund or a large private stakeholder might look at a price drop as an opportunity to buy more.

  • Stay away from closely held companies, i.e. companies where management owns a controlling stock position. As a short in those companies you are effectively at their mercy and that's the last place you want to be.

  • I am not a big believer that if a stock already has a large "short position" against it, it better be left alone. If there is a good reason for a short to be crowded, and the timing catalyst is there, I'll play. But do keep in mind that the mere dynamics of a large Short Interest do make the hill that much steeper for shorts.

  • If the option prices make sense, use puts instead of shorting the stock, but avoid the temptation of "sizing up" the position.

  • Take every opportunity to trade around your short/puts.

  • Respect the charts.

  • Don't be a pig if the position moves in your favor. You may be able to brag about bagging the last $3 of a stock's life, but those $3 are unlikely to be a good risk/reward play.

  • Only play if you understand the bullish case for the stock but you are not swayed by it. If a bullish research note gives you second thoughts, step out and reconsider. The stock will be there tomorrow.

  • I often find it easier to short "themes" (through ETF's) than specific names, because it is a lot easier to see a whole group in trouble than to spot a specific company.

  • And lastly please enjoy an example of what it feels like to have your arse handed to you, and make sure you can accept/afford the same treatment.


I recognize these are broad ideas, but I offer them perhaps as a useful guideline assembled "the hard way."

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No positions in stocks mentioned.
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