Going Short: Sword That Cuts Both Ways

04/05/2011 2:06 pm EST

Focus: STRATEGIES

Gil Morales

Managing Director and Chief Portfolio Manager, MoKa Investors, LLC

Portfolio manager Gil Morales discusses the benefits and important risk factors that come along with short selling, imparting some tips on how to determine a good time to sell short and exposing common mistakes beginners must strive to avoid.

More and more traders are getting comfortable short selling positions, which is a good thing; you want to be able to make money whether the market is going up or down. Our guest today is Gil Morales. He co-wrote a book on short selling to talk about this. So Gil, what are some of the benefits and some of the pitfalls of short sells?

Well I can tell you right off the bat that from my experience as a trader, some of my fastest profits, my quickest profits, and my biggest profits have come from short selling.

I can also tell you that some of my biggest losses have come from short selling. So it's a sword that cuts both ways when you're trying to short sell.

All right, so traders seem to shy away from it a bit. Most newer traders think long the market is the one way to make money. Why do they shy away from it?

Because it is inherently dangerous, and I think you have to take a negative view of things. I don't think it's in people's nature to be negative about things. Generally when somebody buys a stock there's a lot of hope involved. Rather, you have to take the other side of the coin when you're going short.

Is there a better time than another to be a short seller?

Well, there is a right time to be short. In fact, there are very few optimal windows for shorting. Most investors are trying to short too often during a bull market and trying to short stocks that are making new highs. That's a mistake. 

What I do is I wait for a bear market to develop. A bear market top may take two to three months to develop or longer, and what you'll start to see is leadership will break down. So the stocks that were in fact the leaders during the bull market become your targets on the short side because what goes up will tend to come down very sharply. 

You can see that was the case in 2008. A lot of the stocks such as Apple (AAPL), Baidu.com (BIDU), Intuitive Surgical (ISRG) came down very sharply, and they were the leaders in the preceding bull market. So those become your targets because institutional money is what drives those stocks higher on the way up, and as those institutions have to back away from the market and raise cash, those are the positions they'll come flying out of.

Now the rules have changed back and forth over the years where there had to be an uptick before you could short sell. That's gone away for a while, now it's back. What are you in favor of there?

I actually am in favor of the uptick rule. As a short seller, you can't really gauge whether you're getting natural sellers or short sellers because everyone can hit the bid. In the past, you could get a sense of whether a stock is being taken out by shorts or whether you have natural sellers because they'll just see the bid getting hit. So it does throw you off a little bit and actually has made the short sale game a little bit more difficult more recently.

It affects your ability to short sell by being able to find shares to borrow. Are some brokers better than others at doing that and how do I find shares to borrow?

Well generally the more liquid stocks, the bigger stocks, like the Apples of the world, Intel (INTC), Cisco Systems (CSCO), things like that, they'll be more available to short. The thinner stocks are more difficult to borrow, but I do always try to borrow and in fact do borrow the shares before I sell any shares short of any stock.

Now borrowing the shares, also you pay a fee for doing that, right? You have to figure that in.

Exactly, right. An investor should ask their broker about that because sometimes it can be actually very large in some cases.

Other rules about being able to short sell or not short sell in a 401(k) or a retirement account, what do I have to consider there?

I don't think you can short stocks obviously, but you can always go long inverse ETFs. That's always a possibility in a retirement account.

But again, the short side of the game is very difficult, and so for retirement money, that's safer, long-term money. I would tend to avoid doing it in that type of an account. I would do it in a high-risk margin account where you can take capital losses.

All right, then finally if I'm going to get started in short selling, I've never done this before, do I start with ten shares, 100 shares, how should I begin?

My recommendation would be that investors looking to learn how to short and start doing it for the very first time should really devote 5% or less of their overall portfolio capital to short selling until they're comfortable and have actually shown that they can make money in the short side. That's what I would recommend.

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