A five-year bull market is a tough time for short selling.
Under normal market conditions, short sellers provide the right amount of pessimism to temper the optimism that leads to a wildly overvalued stock market. Short positions help keep companies with weak earnings potential and bad management from riding the bull market herd mentality to unjustifiably high share prices.
But this market is far from normal.
The 2014 stock market has seen the major indexes routinely hit new milestones – the Dow Jones Industrial Average has closed at a record high 15 times this year – which doesn't create an environment that encourages short selling, said Money Morning's Capital Wave Strategist Shah Gilani. Gilani is editor of the Short-Side Fortunesinvestment service and has decades of experience in betting against the market.
That's why short sellers are making less of a showing in the markets than they have since the start of the financial crisis. The Financial Timesreports that the proportion of shares in short positions is at its lowest level since before the collapse of Lehman Brothers, with short interest on the S&P 500 index hovering around 2%.
But even in these exuberant times, there is still room for the skeptic to make a profit betting on the downside.
"It's hard to fight this bull market," Gilani said. "I'm shorting a lot less than I used to – but I'm always looking for opportunities and there are always opportunities."
Booming asset prices don't shield bad companies from taking a dive, and the current bull market shouldn't preclude bets against it – as Gilani knows. He recently scored his subscribers more than 300% in profits by betting one stock would tumble.
"As sure as markets go up, they go down. All asset classes go up, and they all go down," Gilani said. "Personally, I love it when things go down – because they always go down a lot harder and faster than they go up."
The Basics of Short Selling
Shorting a stock involves borrowing it from a broker at one price with the promise to return those shares after a certain period of time. The short seller will then sell the borrowed shares, and if the stock price goes down, they can buy them back, return them to the broker, and pocket the difference.
However, unlike taking a long position, where the biggest risk to investors is that they lose only the money they invest, if shares continue to rise, there's no ceiling on how much short-sellers can lose when they buy back the shares. This can lead to covering the short in a panic just to prevent further losses.
Investors don't have to limit themselves to shorting companies; they can short currencies, ETFs, indexes, and any number of other investment vehicles.
The savviest short sellers put a lot of effort into "forensic analysis," Gilani said. They dig deeply through the companies' books, look through footnotes in SEC documents, keep an eye on management, and try to look for any indication that share prices are due for a downward correction.
Investors can also profit from a company's losses on the futures markets, most notably by buying put options. Put options are contracts that grant the right to sell an underlying security at a set price before a specific date. If the shares dip below the agreed upon price in the put contract, the holder of the contract can buy the shares at the lower price and sell them to the option writer at the higher price for a profit.
And that's how Gilani delivered a 345.5% profit for his subscribers, using a stock that flashed a major warning sign of looming decline…