Short Selling Can Be a Tricky Proposition. To Make Money Doing It, You Need to Adhere to these Simple Commandments.
The market is a two-way street. Sometimes traffic flows up, and investors who own stocks (who are “long”) make money. And sometimes traffic flows down, and those investors lose money. But there are some investors who make money when stocks fall (as they did in the fourth quarter of 2018, and perhaps during last month’s mini-pullback)—investors who are “short” the market—and if you’re nimble enough, you can successfully join them. But selling short is not an enterprise to be undertaken lightly; it’s an easy way for amateurs to lose money!
So before you enter into this arena, consider my rules for selling short in the stock market.
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5 Commandments for Selling Short
1. Thou shalt sell short only in bear markets.
“The trend is your friend” is one of the most valuable of the scores of market truisms that I’ve internalized over the years.
Over the past 10 years, the market’s trend has been up, and anyone who bet against it (hedge funds, for example) suffered.
But a bear market might not be far off (we came within an eyelash of one during the fourth-quarter 2018 market correction); when it happens you can garner some good profits by selling short, by investing in sync with that downtrend.
That said, you don’t want to jump the gun! The biggest reason for shorting only in confirmed bear markets—and most people forget this—is that the real long-term trend of the market has been up for centuries, and will continue to be up as long as investors perceive that the U.S. economy is growing. Usually, this long upward trend helps investors, which is why holding index funds for decades is one decent investing strategy.
If you want to invest contrary to this upward trend, you better be darn sure there’s a real bear market in force to help you.
2. Thou shalt sell short only stocks that are trending down.
This rule, like the first, ensures that the odds are on your side when you short. Trends, once in place, tend to continue, so you want to be sure that the stock you’re shorting is already in a downtrend. Sure, it’s nice to dream about shorting a ridiculously overvalued stock at the top and riding it down, but picking tops (and bottoms) is a fool’s game. Put the odds in your favor and only sell stocks short that are in confirmed downtrends.
3. Thou shalt sell short only when public opinion of the company behind the stock has a long way to fall.
Stocks decline because investors as a whole lower their expectations about the stocks’ future—and when they do, some stop buying and others start selling. For little-known stocks, expectations can’t fall much because there aren’t many expectations. If anything, expectations are likely to rise as people discover the company and the stock.
It’s far better to short stocks that are over-owned, and stocks that are or were well loved, and which are thus ripe for lowered expectations.
Chipotle (CMG) was a classic example of that. When everyone loved the stock back in 2015, it was “priced to perfection.” And once the bad news about contaminated food got out, the stock had nowhere to go but down—and once the downtrend got rolling (with selling intensified by repeat incidents), it was hard to stop! In fact, at the stock’s low, it was off 67% from its 2015 high, even though revenues were down only 9% from the peak. (Trouble is, earnings were down 71% from the peak.) Chipotle stock has since completely recovered, trading at new all-time highs as of this writing. But the recovery took a couple years.
Blockbuster Entertainment is another great example. At its peak in 2004, it dominated the video rental business. But then Netflix (NFLX) came up with the revolutionary idea of mailing DVDs, and that marked the start of Blockbuster’s big decline.
Kodak is another classic example; once king of the photography industry, it was killed by the digital revolution.
So what stocks might be good shorts in the future—once this bull market rolls over? Off the top of my head, I’d keep an eye on these current favorites:
Canon (CAJ) is an old-school photography company facing competition from digital upstarts; in fact it’s easy to draw a parallel with Kodak. Revenues peaked at $45 billion in 2011; last year they were just under $36 billion. The stock peaked above 40 in January 2018 and has been trending down since.
Cummins (CMI) is the king of diesel engines, but the recent activities of executives at Volkswagen and other German automakers in skirting pollution laws have made perceptions of the business increasingly “dirty” and investors have been selling the stock since early 2018.
R.R. Donnelley and Sons (RRD) has a long and distinguished history as a commercial printer, but the trend toward digitization has forced the company to diversify into other business services and earnings have suffered. The stock peaked in July 2016 and has been trending down since.
Triumph Group (TGI) is not as well known as the other companies here—it’s a supplier of aerospace services, structures and systems to aircraft manufacturers (like Boeing and Airbus). But revenues peaked in 2015 at $3.9 billion—and the stock has been trending down since 2013, as investors saw the top coming.
Xerox (XRX) is well known as the inventor of the pioneer copy machine, but its glory days are long over. Furthermore, a recent fight with activist investor Carl Icahn resulted in the resignation of the Chairman, the CEO and six members of the board of directors. The stock peaked at 37 in 2014 and hasn’t gotten back to that level since.
But don’t forget Commandments #1 and #2.
4. Thou shalt, at all times, beware of the mathematical realities of short selling.
When you buy a stock, hoping it will go up, the most you can lose is what you invested—while there’s no limit to what you can win. That’s a pretty good trade-off.
However, when you sell a stock short, the very best result—if the stock falls to zero—is that you double your money. But if the stock goes up instead, there’s no limit to the amount you can lose! That’s not a great trade-off.
5. Thou shalt not get greedy.
When you put it all together, it becomes clear that selling short is a high-risk proposition that can only work during certain periods, and even then, it’s unlikely to work for long. So when you find yourself with a profit from selling short, take some off the table. Let some ride, if you like, but remember that eventually, the market’s long-term upward trend will return, and it will be hard to swim against that tide.
Timothy Lutts heads one of America’s most respected independent investment advisory services. Each week, Tim personally picks the single best stock in his exclusive Cabot Stock of the Week advisory. Build your wealth and reduce your risk with the top stock each week for current market conditionsLearn More
*This article has been updated from an original version that was published in 2014.