In their effort to capture all the profit they can, many investors focus exclusively on buying stocks. That's too bad because it means they're missing out on half the profits - literally.
I say that because the markets move in two directions - up and down - which means there's plenty of profits to be had in both directions.
George Soros, for example, made a cool $1 billion in a single trade that famously almost broke The Bank of England in 1992.
John Paulson made billions off the housing crisis when it hit by going against the grain.
Doug Kass of Seabreeze Partners is known for betting against the herd and laughing all the way to the bank.
Obviously, shorting stocks isn't for everybody - it takes a lot of guts and more than a little conviction to do it profitably. Not to mention a healthy dose of discipline.
But done right, it can really boost your profits...
How to Short a Stock
You have to have brokerage approval and an appropriate amount of collateral on hand to do it. That's because, technically speaking, you're "borrowing shares" to sell them before you actually own them.
When you buy a stock, you are laying out cash at a specific price and hoping to sell it later for a higher price. You believe the price of that stock is going to rise.
When you short a stock, you are doing the exact opposite. You believe the price is going to decline so you sell it first and then buy it back at a later date and presumably at a cheaper price. Cash proceeds from selling are transferred into your account immediately.
When you want to exit a short trade, you have to "cover" the trade, meaning you have to buy those same shares at the prevailing market price and replace the ones you've borrowed from your broker.
The difference between what you received when you sold and what you paid when you exited is your profit. Of course, if the stock actually rises in price, the difference is your loss because it will cost you more to buy the same shares you've already sold.
Clear as mud? Here's a simple example that may help.
Let's say George thinks XYZ is doomed, so he checks with his broker to see if those shares are available for shorting - meaning the broker has them in "inventory."
The answer is yes, so George sells 100 shares of XYZ stock short at $100. He collects $10,000 in proceeds for his troubles. That money is deposited directly in his brokerage account.
A few months later, the price of XYZ has indeed fallen by 75% all the way to $25.
George decides he's not going to be greedy so he elects to buy the shares back or "cover" the trade, as it is known in trader-speak. So he takes the $10,000 he received when he sold and spends $2,500 of it to buy back the shares and return them to his broker.
The $7,500 difference between what he received and what he used to buy his way out of the trade is his profit in this example, excluding transaction costs that I haven't included here for simplicity's sake.
Obviously the reverse is true, too. Had XYZ's price risen above $100, George would need more money to buy shares back, so the trade would have been a loss had he exited at that point.
My Favorite Stocks to Short Now
So how do you find the best "short" candidates?
That's like asking what flavor of ice cream you like. There are as many ways of finding compelling short candidates as there are ways of finding exciting upside opportunities. Some are technical while others are fundamental.
I prefer a far simpler approach that combines social, technical, and fundamental data.
Media darlings make great short candidates because the hype machine is in high gear and people aren't thinking about what a stock is really worth when it's in the headlines every morning for all the "right" reasons.
Technically speaking, I love charts that look like ski-jumps, especially when they're media-driven and the companies in question have no logical path to profits. Nothing goes up forever.
But I positively turn into a drooling idiot when I see companies that no longer have a valid investment premise because that means the business case for their survival is tenuous at best. Ultimately that translates to lower earnings and a complete failure on the bottom line.
In that spirit, here are four companies that I believe are great shorts right now:
Sears Holdings Corp. (Nasdaq: SHLD)
This is an iconic brand that I don't think will be around in 5 years. Retail industry foot traffic has fallen by 50% in the past 3 years, according to the Wall Street Journal. Sales have fallen for 27 straight quarters. The company has not made the jump online effectively.
Many experts believe Eddie Lambert's done nothing but muck up the company since his high-profile takeover in 2005 (he became CEO in 2013). Yahoofinance.com shows that the beleaguered retailer lost $544 million last quarter on revenues of $37.86 billion. Ouch!
Maybe he can spin off some of its brands like Lands' End, Kenmore, and Craftsman, but that probably won't amount for much more than a few bucks here and there. It's certainly not enough to stem the company's cash-flow problems.
J.C. Penney Company Inc. (NYSE: JCP)
This is another retailing icon destined for the boneyard of dead corporations. It's closing stores left and right. It recently laid off several thousand workers and won't see any of its recent cost-cutting actions hit the bottom line until 2016.
If it makes it that far...
CenturyLink Inc. (NYSE: CTL)
When was the last time you bought a landline? 'Nuff said... I told you this didn't have to be complicated, and I wasn't kidding.
And, finally, drumroll, please...
Facebook Inc. (Nasdaq: FB)
I've been a lone wolf in the mountains on this one since the IPO. The company isn't worth $7 let alone $70. When the number of new users declines past a critical point, the company is dead. The debate about mobile users, monetization, and eyeballs is no more relevant now than it was for Pets.com during the dot.bomb era.
Interestingly, two researchers from Princeton's Department of Mechanical and Aerospace Engineering agree with me. They made waves recently by suggesting that Facebook could lose 80% of its users between 2015 and 2017.
Naturally the Facebook faithful cry foul, but then again so did the BlackBerry fanatics when that stock was on top of the world in June 2008 and trading at nearly $145 a share. It's $10 today.
In closing, there's obviously more to short selling than the simple explanation I've provided, so check with your broker.
But do check...
...you'll never forget the first time you profit while other investors are left crying in their beer wondering what happened.