4 Important Lessons for Short Sellers

04/23/2012 12:12 pm EST


Recent news and price action for First Solar (FSLR) put short sellers in a compromising position, writes Bryan Sapp, citing four valuable lessons for short sellers and contrarians in general.

Here at Schaeffer’s, we consider ourselves contrarians who look to fade calls by analysts, financial writers, magazine covers, the public, and any other reliable indicator of overall market sentiment. There are numerous ways that we gauge sentiment by each of these groups, but the easiest things to potentially fade are upgrades/downgrades, earnings, and breaking news on specific companies.

There is a glaring example today where being a contrarian could’ve made you a small fortune, while running with "the herd" surely would’ve gotten you shorn.

I’m talking about First Solar (FSLR). The stock has been in a strong downtrend since February 2011, and there is seemingly no floor in sight for FSLR (or the solar sector as a whole, for that matter).

See also: Solar Stock with Rather Dim Prospects

Prior to last Tuesday’s market open, trading on FSLR was halted because of pending news. The company then announced it will lay off 30% of its workforce, a move that to most fundamentalists is basically saying, "We can only stay in business by cutting costs, since our revenues are sliding."

While you might think this sort of news is extremely bearish for the company, it actually traded much higher and closed the day up over 10%. The flip side of this is the eternal optimist viewing this move as a way for FSLR to juice its margins in the coming quarters by cutting costs.

Fast-forward to now, when FSLR has been upgraded by numerous firms, including Argus, Cantor Fitzgerald, and the behemoth Bank of America (BAC). My Twitter stream lit up with bulls pressing their longs, claiming the stock was going to $25 today. On the open, quite the opposite happened, as FSLR gapped up by about 3% and then went into a freefall. The shares are currently trading down by over 5.5% and are near their lows for the day.

A few lessons can be learned from the price action in this name over the course of the past week:

1) It is extremely difficult to short (and stay short) stocks that have a high percentage of their float already sold short.

The most recent short-interest data shows that nearly one quarter of FSLR’s float is currently sold short. This creates the potential for strong short-covering rallies, as evidenced by yesterday’s dramatic move.

Additionally, stocks such as this can act in the opposite fashion to the old market mantra, "Buy the rumor, sell the news." For some highly-shorted stocks, it should read, "Sell the rumor, buy the news." This sounds foolproof, but there’s one glaring issue: knowing when the news will actually surface. For this reason, we prefer to go long underloved, highly-shorted names, and look for "analyst darlings" to initiate short positions on.

When trading leveraged vehicles such as options, a move against you—such as this one in FSLR—can crush a position in a hurry. On the contrary, being long a call option on a stock undergoing a short squeeze is more fun than riding a roller coaster.

2) Don’t read too much into the news itself, but look at the actual reaction to that news.

I’ve said this a few times in other blogs, but I’ll repeat it again, since it’s so important. The news isn’t what matters; it’s the market’s reaction to that news that is noteworthy. The action in FSLR tells me that this is nothing more than a shakeout of the weak shorts.

Sentiment toward the equity has been extremely bearish for some time, with many expecting an eventual bankruptcy. The recent gap up was a gift for yesterday’s short-term traders to sell into (and for potential new shorts to initiate positions at chart resistance levels).

3) Do your homework, initiate your own trades, and don’t blindly follow an analyst’s recommendation.

Third, as a full-time trader, I always have people asking "What’s a good stock to buy?" If you’re actively managing your own money, and you have to ask others for that advice, you’re surely set up to fail. You’re much better off fading upgrades and downgrades then piling into them after the fact.

4) Don’t underestimate the importance of sentiment.

Most of the information that you will see as a trader is already "priced in" to the market. Markets are very efficient, and news gets absorbed quickly. Don’t assume that you know something everyone else hasn’t already seen, and attempt to stay on the other side of the crowd.

By Bryan Sapp of Schaeffer’s Investment Research

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