Sell Short: A Simpler, Safer Way to Profit When Stocks Go Down

04/01/2009 10:19 am EST

Focus: OPTIONS

Michael Shulman

Editor, Short-Side Trader

The interest in short-term trading of stocks went nuclear during the late 1990’s as the dot.com stocks surged, but unfortunately, not many of the novice daytraders learned how to sell short, and therefore few survived. Traders and investors now seem better prepared to trade the short side of the market, and Michael Shulman’s new book, Sell Short, should help teach investors about bear market strategies.

Since the financial crisis hit in 2007, Michael has been a regular guest in the MoneyShow.com studio, and I am acquainted with his early bearish stance on the financial stocks as well as his views on the markets. Michael is a strong advocate of using put options to benefit from a stock or sector’s decline and feels that the risk of actually shorting individual stocks is too high. 

Michael maintains that this book “is not a trading system, nor is it a set of hard and fast rules for a particular kind of fundamental analysis. Rather it is a method geared to individual investors, financial advisors and money managers unfamiliar with and (probably) uncomfortable with putting money to work on the dark side.”

Throughout the book, you are guided through a series of steps to assist you in developing a strategy that fits your individual situation. In the first chapter, for example, the author suggests that you determine what part of your portfolio to commit for shorting and reminds you that only risk capital should be used. He also reminds you to never put more than 5% of your shorting capital into any one position, and that the goal is for the put option you purchase to double in value. At the end of each chapter, there are a few questions, presumably from his newsletter subscribers, and a concise summary of the rules covered in the chapter. I found this to be a wonderful feature that made the book quite user friendly. After making a strong case for why put options are the best vehicle for selling short, Michael discusses what he calls “prospecting,” or the process of using fundamentals to pick a target company to sell short, and includes some of the methods that are used in his analysis. This is followed by a chapter on technical analysis, which he feels should be kept simple. Also discussed are some methods specific to shorting and put buying, specifically the days needed to cover outstanding shares sold short and how to examine the shorting activity in a stock as part of your selection process. I am quite sure these are both factors that many put buyers do not look at, but nonetheless, they are quite important.

The nuts and bolts of establishing a position are covered in chapter six, titled “Creating a Position.” This chapter contains relevant information that one could use to sequentially go through the process of establishing a put position. Those that I found to be the most helpful in selecting a shorting candidate and establishing a position were: Finding a disconnect between the company’s story and your view of reality, picking a price target, setting time stops, and lastly, watching out for what Michael calls “deadly surprises.”  These surprises are a type of catalyst, and assessing the risk of a catalyst, i.e. news events, buyouts, mergers, or anything else that can quickly hurt your put position, may be difficult. There is one chapter devoted to traditional short selling, and it also covers how to establish a short position in a market segment or a major index. Michael correctly points out that far too often, put buyers are unsuccessful because they trade illiquid options, and cautions that you should stay away from thinly traded options at all costs.

In my experience, one of the more difficult parts of making money with puts is managing the position, and I was pleased to see that chapter 11 addresses this very topic. This chapter is a must read as Michael shares his thoughts on when to press a position, how to ride out a short squeeze, and when you should consider exiting a position even though your 100% profit target has not been met. 

In this book, considerable groundwork has been done on shorting commodities and real estate, shorting a country, and advanced techniques. One of the advanced techniques that is mentioned throughout the book, and is discussed in detail in Chapter 15, is what Michael refers to as “the rocket-fueled trade.” Briefly, this is where you buy a call on a double-short ETF, and though it is not for most traders, the author does feel that it should be considered.

The book concludes with a number of case studies taken from those he recommended to his subscribers. Whether or not you have ever bought a put, your understanding of selling short will certainly be enhanced after reading this book. If you have never traded put options, this book should start you off on the right track, and even if you have some experience with options, Michael’s insights should improve your trading.

Related Articles on OPTIONS