Successful Short-Selling Guide

A successful short seller combines a sober eye for fundamental value with aggressive market timing instincts. An investor who sells short needs an analytical understanding of how to value a company's business in order to identify overpriced stocks. A short seller also needs to seize the opportunity when the price dynamics signal a selling opportunity. A successful short seller combines the traits of a long-term investor with a short-term speculator by using his or her skills and understanding of financial statement analysis, industry knowledge, financial projections, money-management, price trend recognition, risk-reward analysis and emotional discipline to identify and profit from short selling opportunities.

The task faced by a short seller is extremely challenging. To better understand the difficulty, imagine that you are trying to predict when the ground you are on will slope downward. Imagine you are trying make the prediction after you are suddenly placed on the lunar surface. You are able to look only straight ahead. You can move only by walking backwards. You see that you have been placed in a broken, hilly terrain that is steadily increasing in elevation. At some point, as you walk backwards, you will place a sizable bet that as you continue to walk backwards you will wind up at a lower elevation. If you are correct, you will make money. If instead you continue to head uphill, then you will lose money. How can you, in this situation, predict with confidence that as you continue walking you will head downhill?

This is similar to a short seller's uncertain position. A short seller can only see what has happened in the past, but must try to predict the future. The stock market is very choppy, but stock prices have tended to rise over time. Like the lunar explorer trying to predict the ground's changing slope while blindly walking backwards over unknown terrain, the short seller must try to predict prices while heading blindly into an uncertain future.

The lunar analogy provides a clue to a strategy for the short seller. The lunar explorer would probably feel safest predicting the ground would continue to slope downward when he had reached a point much higher than the surrounding terrain but then had started moving downward. Similarly, a short seller can be most confident of a successful short sale when she sells a stock that is priced very high relative to other stocks and the price is starting to move down.

The short seller will develop an appreciation of the many elements that need to be in place for her to be reasonably confident that the price of the stock she shorted is going to fall. Before she can place a short sale with confidence, she will need to find satisfactory answers to questions of valuation, market perception and timing.

The Short Seller's Valuation Dilemma

A short seller's first task is to find overvalued stocks. To find overvalued stocks, the short seller must answer the question: What is a stock worth? The answer: Whatever the market will pay for it. But the market is paying a "high" price for the stock the short seller thinks is overvalued. The "high" price is the true worth of the stock, so the stock really is not overvalued - so no stocks are overvalued. If no stocks are overvalued, the short seller can never find overvalued stocks. This is the short seller's valuation dilemma.

The buyers in the market do not purchase a stock unless they believe it will increase in value. The buyers of the stock that the short seller sells short have reasons to believe that they are purchasing a stock that will go up in price. The short seller, however, has different reasons for believing the stock is going to go down in price.

A short seller must be able to tell two different stories at the same time. The short seller needs a story to explain what the target stock is worth to him. The short seller also must understand the story that the buyers believe which explains why the target stock is worth more to them than it is worth to the short seller.

A Difference in Judgment

A widespread theory says that the market is "efficient" because nearly all the important information about a stock is available to everyone in the market. Information, however, is only useful in forming judgments. The quality of people's judgments varies widely. The short seller tries to take advantage of the poor judgment other people make based on the available information.

The short seller uses the available information and his judgment to tell a story about what the target stock is worth to him. He then understands the judgments that others are making to value the target stock at the higher level. When he has found a stock where his valuation is significantly lower than the current buyers' valuation, he has a candidate for a short sale.

The Short Seller's Price Change Dilemma

Now that the short seller has identified a short sale candidate, a stock that in his judgment is worth much less than what other investors are willing to pay for it, is his work done? No, the short seller comes face to face with another dilemma. As long as this disparity in judgment remains the stock will remain at its lofty levels and may well go higher. It is no use to the short seller to be the lone voice crying in the wilderness, "The stock is excessively valued! It should be selling for half its current price!" Even if a panel of business school professors agree that the short seller is "right" that the stock is overvalued, the transaction could still be a financial disaster. The dilemma for the short seller is that whatever circumstances led to the overvaluation in the first place could remain in place indefinitely and keep the stock price high.

How do we solve the price change dilemma? A short seller has to find stocks that buyers are willing to pay a high price for now, but will not be willing to pay a high price for in the future. Additionally, the short seller must understand why buyers are paying a high price for the target stock. If the short seller thinks that these reasons will disappear in the future, then the short seller has found a short sale candidate.

The Triggering Event and the Reevaluation

As discussed above, a stock is worth what the market will pay for it. For a short sale to be successful, the overvaluation of the stock has to be temporary. The market must reevaluate what it will pay for a stock and decide that it will pay significantly less than it paid before.

An event (or series of events) is needed to trigger the reevaluation. The specific event depends upon the story the market told to justify the original high stock price. If the story is that the target stock's earnings are growing at 50% a year, then the trigger could be a poor earnings report. If the story is that the target company has a unique wonder product then a competitor's introduction of a similar, lower-priced product would make the target company less attractive. If the target company is mainly attractive because of its dividend yield, then a sustained increase in bond yields could make the target company relatively less valuable.

A short seller should identify a trigger event for the target stock. When this trigger event occurs, in the short seller's judgment, the market will reevaluate downward the prospects for the stock and the price will fall. It is more risky to sell short a stock when you cannot identify a triggering event and when you think it will occur. Without a reason for the market to rethink its optimism toward the stock, its price can stay high and keep going higher.

The Short Seller's Timing Dilemma

The short seller is not yet ready to put her money on the line even though she has found an overpriced stock and has identified a future event that she believes will move the stock price lower. The timing of a short sale is crucial for several reasons: short sales are extremely risky, short sales are subject to margin calls, the potential for disaster is greater than the potential for profit, short sale candidates are usually volatile stocks, and emotions often run high and clear judgment is clouded on overvalued stocks.

Refer to the Zitel example discussed in The Short Selling FAQ. How would you feel if you sold Zitel short at $20 per share only to see it zoom up to $30, $40, $50, or even $70 per share? If you survived the margin calls, and if your nerves held out as people bid ever higher a stock you thought overpriced at $20 per share, if you didn't close out your position for a loss, then would it all be worth it to close out your position for a small profit months later when Zitel finally fell back to $15 per share? You could claim with justification that the market validated your judgment that Zitel was overpriced at $20 per share. You could point to your profit and think this was another successful short sale transaction. But would it not have been better to avoid that roller coaster ride, one that your portfolio might not have survived?

What if you were simply wrong? What if you had shorted Microsoft a few years back? You would be a lot poorer now. Is there a way to reduce your chances of making a costly bet against a stock that turns out to be a winner?

Simply, the question is how do you know the right time to place a short sale? No one knows with certainty how the market is going to behave. But you can reduce your risk by understanding the dynamics of supply and demand.

Price Dynamics

The price of a stock is set on the margins, by the buyer who is willing to pay the most and by the seller who is willing to sell for the least. Out of the thousands of people who own a stock and could put it up for sale and the thousands of others who are considering a purchase, only a few dozen may actually trade on a given day. If the stock price is going up, it means that there is more buying interest than selling interest. The first buyers have already bought from the sellers who are willing to sell most cheaply, so that the buyers who come later have to buy their stock from the sellers who want a higher price. The price at which the stock trades rises. Conversely, if a wave of sellers comes to trade and the most eager buyers have already made their trades, then the sellers will have to find buyers among those unwilling to pay as much for the stock and the price will fall.

Stock prices tend to behave like they have momentum. Like a car that cannot switch from heading east at 60 miles per hour in one second to heading west at 40 miles per hour in the next second, stock prices that have upward momentum do not tend to reverse course immediately. Peter Lynch tells a story of his early days as a stock analyst when he bought shares of a stock that had been falling because he thought it was a great bargain. Unfortunately, the shares continued to fall, and fell far further than he thought possible. He likened the stock to a falling knife. His advice was not to catch the knife when it was falling and risk getting cut, but wait for it to stick in the ground when it was easier to grab. In other words, wait for the momentum in the price to stop.

The same advice, to an even greater degree, holds for selling stock short. It is foolhardy to sell short a stock that is steadily increasing in price no matter how overvalued you think it is. The price movement is sending you a clear message about the relative number of buyers and sellers trading the stock. There are more buyers than sellers. The market's judgment is getting further away from your own, not closer. That is the wrong time to sell short.

It is best to sell short when the price movement is supporting your belief that a reevaluation is occurring. Wait for the stock to stop moving up, wait for it to hesitate and then to start falling. If it falls one day, and then falls again, and then one more time, then you can be reasonably sure that the buying demand has been satisfied. The sellers have ceased to be wallflowers and have moved to the forefront. The upward momentum is gone.

Stock prices, of course, do not move like cars. They change direction from one moment to the next and from one day's closing price to the next. Sometimes, a trend is relatively clear. If a stock rises in price more often than not, day after day, that is a clear trend. Sometimes, however, a stock will spurt up, then fall, then meander, then fall for a few days, then shoot right back up. In that case, there is no clear trend. If you had sold short based on a downward move, then you may want to close out the short sale and wait for a more sustained downward move. In a short sale, you need people with judgment like your own to trade the stock, and you have to wait for the people who value the stock more highly to lose their influence.

Like a presidential election, not everyone has to be a Democrat for a Democrat to be elected. Approximately 40% of the voters typically cast their votes for the losing candidate(s). You can have a successful short sale even though a large percentage of people with a position in the stock believe the stock is worth much more than the price at which you sold it short. You are waiting for the tide to shift, for a few people to reconsider their previous high valuation or for a few new people to arrive who share your judgment. As long as there is an imbalance of more selling pressure than buying pressure, the price will fall. Now is the time to go with the flow. Although the current in stock prices tends to go higher, there are eddies when prices make a prolonged move downward. It is these eddies that you are trying to catch when you sell short.

Money Management and Psychology

You are probably interested in selling short to make money to improve the quality of your life. So you want to be careful not to take unnecessary risks or to overextend yourself. If you do, you will likely make yourself miserable from worrying about your stock price movements or the losses you may be suffering.

The financial skill most difficult for many people to master is the management of their own emotions. It is very hard to invest successfully while afraid, greedy, or complacent, or angry, stubborn, or desperate. It is important to take risks that you can live with and to protect yourself against unnecessary risks.

Limit your losses. If a position starts going against you, get out early. Sometimes your judgment will be mistaken. Recognize it early and close out your position. You may take some losses but you will still have enough money left to open another position. By closing positions early you may miss out on a price movement that would have made your position a winner, but that is the benefit of hindsight. At the time, the available information showed your timing or your judgment on this particular transaction was off.

When you have a successful short position, do not close it out prematurely. The falling price of the stock confirms your judgment. After all you went through to identify the stock to short and the timing of the sale, take advantage of your good fortune.

Eventually, the downward price movement will stall and the stock price will start to recover. Then if, in your judgment, the price is near the true value of the stock, then the time has come to close out your position. Even if the downward price movement stalls at a level that you believe is still overpriced, it is often best to close out your short position. Compare the few extra dollars you might make against the chance of losing a great deal of money if the stock price recovers strongly. When you examine the risk/reward tradeoff, you will probably be better off closing out your position and finding a new overpriced stock to short.

Enjoy the short side of investing! Good luck, but understand the risks and exercise caution.