Tags: Keith Fitz-Gerald, Larry D. Spears, SEC, Short Sales, Stock Market, Uptick Rule

The 10 Keys to Short-Selling Profits

By , Contributing Writer, Money Morning •

Short sellers took a lot of flak for their alleged role in the stock market meltdown of 2008-2009, getting blamed for artificially depressing stock prices, exaggerating the impact of the bad economic news rolling out of Washington and exacerbating the volatility that intensified the financial panic experienced by investors and the general public.

That last allegation was particularly troublesome to market regulators, especially after stock-market researcher Birinyi Associates traced a sudden sharp rise in stock volatility back to mid-July of 2007, a point coinciding with the repeal of the so-called "uptick rule." The uptick rule was a Depression-era regulation that allowed the short sale of a stock only when the prior trade had resulted in an upward move in its price.

That concern over volatility led to a lot of official posturing as the government struggled to come up with solutions to prevent future market mayhem, the result of which (at least for the time being) was the Securities and Exchange Commission (SEC) Feb. 24 adoption of a new "alternative uptick rule."

The new rule, approved after much debate by a minimum 3-2 vote, imposes a ban on the short sale of a stock after its price falls by 10% in a single trading day. The rule's ultimate purpose, according to SEC Chairman Mary Schapiro, is "to preserve investor confidence and promote market efficiency."
  
Unfortunately, the new rule really does neither. Indeed, it's essentially a lukewarm compromise with no teeth, primarily designed "to make politicians and regulators feel like they are doing something," says Chuck Jaffe, a market commentator and columnist for MarketWatch.com.

That means the rule will likely stand only until the next time the market stumbles - and will be largely ineffective in the meantime. It also means that short selling will most likely continue to be a prominent feature of daily stock-market action - which probably isn't an entirely bad thing, says Money Morning Chief Investment Strategist Keith Fitz-Gerald.

"I'm actually a huge fan of short selling," says Fitz-Gerald, which he characterizes as essentially "a bet against a stock."

Short-Selling Basics

Fitz-Gerald uses the "bet" analogy for a reason: Short-sellers search primarily for stocks they believe are poised to fall. Typically, a short sale involves borrowing a troubled company's shares from another investor, selling them, then waiting for the stock's price to decline before closing the position ("covering," as it's called) by buying the shares back on the open market.

The difference between the higher initial selling price and the lower repurchase price represents the short seller's profit.

"It's a really valuable strategic tool," Fitz-Gerald says. It allows you  "to profit on weak companies as well as strong ones, and in bad markets as well as good ones."

But there is a caveat: "You really have to understand what you're doing because, when implemented in its purest form, what you're essentially betting on is a company's imminent failure," he says.

Another point to consider: When an investor buys ("goes long" on) a stock, the maximum possible loss is what the investor paid. With short-selling, however, the loss potential is substantial  (though not actually unlimited, as some claim): If you borrow and sell shares at one price, believing they are poised for a fall, and that stock rallies instead, your potential loss will continue to grow with each advance of the stock. The reason: A rising stock price represents a rising cost to "cover" - to buy back the shares to replace those that were borrowed and sold.

Fitz-Gerald says the added knowledge and a clear understanding of market psychology is vital because short sellers have two things working against them from the outset:

  • History shows us that, over time, the markets have an inherent upward bias. "Investors are optimistic by nature," Fitz-Gerald says. "If they weren't, they wouldn't put their money on the line - and that optimism always works against you as a short seller. You're fighting millions of investors who want you to be wrong - and are betting against you." 
  • When you pick out a company that's ripe for shorting, you move outside the realm of business as usual. "You're not just betting against a company striving to make a decent profit," Fitz-Gerald explains. "You're betting against a company that, quite often, is literally fighting for its survival."

Because of this built-in opposition to your success, Fitz-Gerald says, "You absolutely have to have a very sturdy constitution to do short selling well. If you have any character flaws at all, you'll find them when you start short selling." 

The 10 Rules For Short-Selling Success

In spite of the risks, Fitz-Gerald says the technique "really can be extraordinarily profitable - but only if you truly know what you're doing."

To that end, here are 10 things you absolutely have to know if you hope to become a successful short seller:

1. Timing is far more critical in short selling than when buying stocks. As a rule, Money Morning counsels investors to avoid "market timing." But timing really is critical when short selling, Fitz-Gerald says. He identifies short-sale candidates primarily from fundamentals, but waits to actually take action until signaled to do so by overall market action or specific technical indicators. "My favorite entry point," he explains, "is when we've had a huge up day in the market and the stock I'm watching has gone along for the ride, moving above its Bollinger bands, its Keltner channel or some other statistical measure of that stock's normal trading range. That's because, when I'm short selling, I want every possible advantage working in my favor - fundamental, technical and otherwise."  

A technical trigger is important because it may take some time for the market to recognize fundamental weakness in a company - and even longer to actually give up on the stock.

As an example, Fitz-Gerald cites Garmin Ltd. (Nasdaq: GRMN), which once was the global leader in the mobile GPS-device business. He recently put Garmin on his short-selling watch list because the company is "slashing prices, failing in new businesses and steadily losing ground" in the market for handheld GPS devices, which are rapidly becoming obsolete because virtually every new smart phone being sold includes a free GPS app. In spite of those negatives, the stock rose immediately after its late-February report of fourth-quarter earnings that beat estimates, even though the gains were based on cost cutting rather than improved revenue and margins. That up move could have proved costly had the stock been shorted without waiting for a technical trigger.

2.
Short selling is primarily a short-term strategy. Unlike on the "Buy" side, there are very few successful "sell-and-hold investors." That's due again to the inherent upside bias in the markets. Even when stock prices are locked into a prolonged narrow trading range inflation can push prices up, creating losses for longer-term short positions. In fact, the bulk of short selling in today's markets is done by day traders and swing traders, each of whom wish to take small profits on the normal daily and weekly price fluctuations. Most longer-term short positions are taken by professionals, hedge funds and savvy individual investors looking to offset downside risk exposure on large portfolios.

3. Restrict most of your short selling to bear markets. This seems like an obvious rule, but it's amazing how many traders violate it - and pay a painful price, as a result. Though it sometimes seems like we've been in one for a decade, true bear markets actually come along only about once every 3.6 years and historically last just under 18 months. The rest of the time, the markets are moving upward - and, since numerous studies have shown that the majority of stock gains (perhaps as much as 85%) result from overall market movements rather than internal company fundamentals, it makes little sense to buck the trend. Unless timing is perfect or you find a dying company a day ahead of everyone else, shorting into a strong bull market (or even in the waning days of a bear move) is like swimming against the tide - and it's almost certain to thoroughly dampen your returns.

4. When there is a bear market, short selling gives you a significant edge. Stock buyers and traditional buy-and-hold investors really have only two options when a bear market strikes (okay, three if you count hedging your holdings by purchasing "put" options). Investors can either endure the losses and try to ride out the downturn, or liquidate their stock positions and move into cash or other assets. But if you understand short selling and are willing to use the technique, you can quickly exit your long stock positions - avoiding the bulk of the loss - and then sell the same stocks (or worse ones) short, picking up new profits as the market continues to fall and other investors cry over their losses. 

5. Being early is much riskier on the short side. If you buy a stock and have to wait awhile before it finally takes off, the upward bias of the overall market reduces your risk - in many cases costing you nothing but the time value of your money. The opposite is true when you sell short. Not only does the upward bias of the market work against you, but there are also interest and margin costs associated with borrowing the stock you sell short. (You must have a margin account with your broker in order to sell short; short selling isn't permitted in a regular cash account.) Even worse, it's always possible for even the most overvalued stock to move higher in price. The dot-com bubble provided painful proof of that fact as many stocks in that sector achieved overvalued status as early as 1998, but would have killed anyone who shorted them in 1999, since the bubble didn't finally burst until 2000. In short, never short a stock simply because you think it's overpriced.
 
6. Action on the short side is much quicker than action on the long side. Numerous market studies have shown that, on average, stock prices decline three times faster than they rise. There's also an old market maxim that says that bad news travels 10 times faster than good news. Both are based on innate human emotions - fear and panic being far more powerful forces than greed and exuberance. Thus, if your timing is good as a short seller, you can generally expect far quicker results than you'd get on your long positions. Even so, always be aware that a crash or panic sell-off isn't required for a successful short trade. In many cases, a simple lack of news will be enough to quell buying interest and cause a price decline sufficient enough to produce a nice short-selling profit.

7. The risk on short positions can be high - but contrary to the popular notion, it's not unlimited. Conservative advisors scare many clients away from short selling by claiming it has unlimited risk. "When you buy a stock," they say, "all you can lose is the amount you paid because its price can't go below zero. But there's no limit to how high a stock's price can climb, and your short position will lose money all the way!" This is actually false on two counts:

  • You should never institute a short position without simultaneously entering a stop order to get you out if prices move too far against you. (Your own goals and risk tolerances will help you determine where to put the stop, but we recommend an absolute loss limit of 25% on short sales.)
  • Your broker won't allow you to unwittingly lose more than your original margin deposit. If your equity in the position drops too low, you'll be asked to either cover your short or deposit more funds. (Don't!) If you do neither, the brokerage firm will liquidate your position to protect its own assets, since it must cover unsecured client losses.

8. If the stock you sell short pays a dividend while your position is open, you must pay the dividend to the broker you borrow the shares from. This is true - and it's a major reason lots of people shy away from selling short. If you really know what you're doing, however, this should never be an issue. After all, why would anyone in their right mind consider shorting a growing company with solid earnings sufficient to allow payment of a decent dividend? On the other hand, if a company cuts or eliminates a dividend, it might be a stock worth shorting, since such a move almost always indicates deeper problems at play.

9. Not every stock can be shorted. As a rule, brokers will not allow you to short a stock priced below $5 a share (too much opportunity for monkey business in the penny stock ranks), nor will you usually be able to short stocks that are very thinly traded or that have too small a float. In those two latter cases, it's too difficult to find shares to borrow, and the lack of shares means volatility will be high, increasing risks.

10. The "short squeeze" is a real risk - but it can be minimized. As noted earlier, overpriced companies - even those with terrible fundamentals - can sometimes defy logic and move still higher. If they do so dramatically - perhaps even "gapping up" at the market open, traders who are short the stock may become fearful and put in panic "Buy" orders to cover their positions. This can push prices still higher, triggering protective stops, which can generate another gap, creating a new round of buying and perhaps even a self-generating uptrend - a classic "short squeeze."

If you get caught in such a squeeze, you'll usually have to bail out - though there are two ways to avoid such situations:

  • Don't short stocks with "squeezable" characteristics, such as a high short-interest ratio, a small float, a low daily trading volume, strong bullish sentiment or advisory support, a record of past short squeezes, or a still-intact uptrend.
  • Maintain strict discipline. Always use a stop-loss order, adjust it regularly as the stock price moves in your favor - and, if you see any of the conditions listed above, either tighten the stop or go ahead and take your profits.

As we wrap up this short-selling treatise, here are two other quick points to keep in mind:

  • If you decide to give short selling a try, take some time to brush up on your technical-analysis skills, with a particular emphasis on recognizing topping patterns and determining the strength of a downtrend. Topping patterns are far more accurate in predicting downturns than bottom patterns are at generating "Buy" signals - that's why you hear lots of market talk about base building and none about roof construction. Similarly, uptrends never last forever, but downtrends sometimes do - with all sorts of bad news potentially capable of leading a company into bankruptcy. Don't overlook the possibility that a downward reversal triggered by a negative report may be just the tip of the iceberg that will ultimately sink a corporate ship.
  • Exercise discipline and use good money management. Always use stops and set targets to give yourself a favorable risk/reward ratio - 4-to-1 will let you be wrong half the time and still make a healthy profit overall. Remember, the best investors aren't right all the time; they just lose the least amount of money when they're wrong.

Follow these tips, hone your analytical skills - both fundamental and technical - and you could wind up looking forward to bear-market profits just as much as you do to bull-market gains.

[Editor's Note: Twenty-two picks. Twenty-two winners. For the past year, Money Morning Chief Investment Strategist Keith Fitz-Gerald has maintained a perfect record with his Geiger Index advisory service. Every trade has turned a profit. That's remarkable in any market, but given the uncertainty that seems to dominate the headlines these days, The Geiger Index advisory service offers unparalleled security and profit opportunities. To find out what other investors have to say about the service, as well as the secret ingredient that makes the Geiger Index go, read on.]

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