In previous posts I discussed the mechanics and nuances of short selling. Today I’ll give some advice on when it is appropriate to sell short.
In general, short selling is a poor idea. Because the market has a natural upwards bias, time works against the short seller. Also, when you are wrong your losses grow and grow, forcing you to find additional cash or pay margin interest. In some cases you may actually be right about the final demise of a stock, but the fluctuations in the mean time force you to cover the position before the stock falls. I therefore only sell short in special situations.
The time when it may be worth selling short is when the market is so unbelievably over-valued, or the likelihood of the market falling is so great (like in the summer of 2008), that stocks in general, or at least in a certain sector, are much more likely to fall than to rise. In general, even in this case short selling is done only as a hedge for long positions – trying to offset losses in long positions by going short on other stocks.
For example, in the summer of 2008 the housing bubble was threatening to burst. I owned a lot of retailer stocks that I knew would be hurt if consumers were no longer able to roll their credit card balances into their home loans, but I did not want to sell the stocks outright. I decided therefore that shorting some of the lenders would be a good hedge.
Since the lenders had been doing very well and the price of their shares had risen a lot over the past few years, I reasoned that their stocks were not likely to go much higher unless I was very wrong about their earnings prospects. I also felt that they would get hit hard when the ARMs reset and people stopped being able to make their payments. At least, I thought, that the number of new loans they would be making-which is where they made most of their money-would decrease, causing their stock price to fall since earnings would no longer be growing at their previous torrid pace. I therefore took up short positions in several lenders.
I also saw that oil prices were very high, and that the price of oil stocks was probably as high as it would get. I thought that if the economy slowed down, demand for gasoline would fall. Because the shares were already at high prices, I reasoned that they were unlikely to go a great deal higher.
Even though I was eventually right and did very well in 2009 while most were taking large losses, it was not uneventful. Shortly after I took up a short position in Golden West Financial, the stock was bought out, jumping from about $20 to the mid-thirties in a day. Eventually Golden West Financial gave great heart burn to the company that acquired them. I was right about the future of Golden West’s business, but that was of little solace to me because I had already lost quite a bit on the trade when the company was acquired (I had a similar experience with Snapple).
So to sum up, short selling can be profitable, but the interim movements of the stock you are shorting can cause losses, even if you are eventually right about the company. Also, just because a stock is very expensive doesn’t mean it can’t go higher for a while or that another company might not buy it out for even more money. I therefore only sell short when I believe there are systemic risks in the market and I wish to hedge against a fall rather than selling outright. I also only short stocks that I believe have gone up so much that they have more room on the downside than the upside.
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.