With Europe on the ropes and the U.S. economy in shambles, it’s important to remember that there are two sides to every trade. Tapping into upward momentum alone is not the only way to profit. Markets can and do head south on a regular basis. Investors who fail to grasp this are leaving a lot of money on the table.
Nobody knows for sure. But stories about famous traders like George Soros who broke The Bank of England and reportedly scored a cool $1 billion profit abound.
People also speak in awe of John Paulson who made billions off the housing crisis and about Doug Kass of Seabreeze Partners who is about as gutsy as they come when it comes to making hay when the sun doesn’t shine.
If you’ve never heard the term before — and many investors still haven’t — shorting stocks involves selling stocks before you buy them and profiting as they drop.
Why would you do that?
Shorting overvalued stocks can lead to profits when others are crying in their beer. It’s a way to keep you fully invested or otherwise in the game, especially when the markets are as unsettled as they are right now.
But you have to be careful. Despite the fact that shorting stocks can be a quick path to riches, not all stocks are the same when it comes to betting against them.
In that sense, short selling (at least the way I encourage investors to practice it) is no different than regular upside investing.
You want to diversify your holdings and use very strict risk management to control your exposure by not having more than 2.5% of your assets in any one position or 20% of your holdings in any given sector.
You want to short stocks in conjunction with the rest of your holdings, not in lieu of maintaining a properly concentrated portfolio. Despite what you may think, shorting stocks is not a game for market-timers or an exercise in timing.
As for how you select your target, that’s not really different either.
How to Find Short “Targets”
For example, you don’t ever want to bet against a stock just because it’s expensive or even overvalued. Instead, you want to find a compelling reason for failure or a lower valuation.
At the time, I reasoned that:
- Apple was a bubble based on technical parallels to the Nasdaq bubble of 2000.
- Its products were faddish and driven by new product launches rather than sustained production.
- A change in leadership may produce slower or greatly varied product development.
- Short interest was an ultra-low 9.8 million shares; it seemed logical to take the other side of the bet if everybody was so bullish.
- Analysts were almost uniformly bullish which is a very bearish sign, according to past corrections.
- Apple’s profit margins were disproportionately high in its industry.
- A carrier failure or subsidy change may soften the company’s fundamentals.
Apple rose a bit further to a peak of $644, then fell 17.68% over the following few weeks to $530.12. It’s still down today at $576. And yes, I think it will fall further in case you’re wondering.
Other negative attributes I look for include insider selling and problematic accounting. Both can be hard to spot in a timely fashion but that doesn’t mean you shouldn’t look.
Armed with a good dose of skepticism, you can find companies that are likely to fall apart in pretty much any market anywhere in the world if you look hard enough.