Few investors naturally go short on stocks considering they really don?t know what to anticipate. Some investors see the process as somewhat counter-intuitive to the notion that stocks do appreciate over time. That said, there is a lot of money to be made by shorting. The first thing you must consider while going short is look at a chart of the stock you are thinking about shorting. What is the general trend? Is the stock under accumulation or distribution?
It is perceived that a stock continues to get trade in the downtrend for an extended period of time. A declining trend will make it difficult for an investor to gain on a move higher because the position will need to fight against the major underlying trend, which in this case is downward.
Also, in the fourth quarter you will note that companies that are trading in the lower end of their 52-week trading range will trade even lower. Why is this? It is because individuals and mutual funds want to book some of their losses before year-end to reap the tax benefits. Therefore, these type of stocks may make good candidates for traders seeking to profit from a move lower.
The languishing trend
You need to see whether a company is languishing in terms of its overall fundamentals for big holders of the stock, such as mutual funds, to get fed up and dump the shares. Look for companies that have declining gross margins, have recently lowered future earnings guidance, have lost major customers but you need to be aware at all times that where there is one (problem), there is probably a whole bunch more.
Besides, if a company shows a sizeable inventory jump for no reason, it is a sign that it has goods on its books that are stale, and might not be saleable. These, in turn, will need to be written off, and will have an adverse impact on earnings down the line. Increasing receivables is a bad sign because it indicates that a company isn?t being paid by its customers on a timely basis.
This will also throw off earnings going forward. If some of these debts ultimately prove to be uncollectible, they will also have to be written off as well at some point in the future.
Sector issues
While a company will occasionally buck a larger trend, most companies within a given sector or industry trade in relative parity. It means that supply and demand issues facing one company are likely to impact others at some point down the road. Use this information to your advantage.
The risks
It is seen that stocks show an upward drift. Over the long run, most stocks appreciate in price. For that matter, even if a company barely improves over the years, inflation should drive its stock price up somewhat. What this means is that shorting is betting against the overall direction of the market. Also, when you short sell, your losses can be considerable
Shorting stocks involves using borrowed money, otherwise known as margin trading. And any counter-trend demonstrated by your stock can be an optionless loss for you.
If a stock starts to rise and a large number of short sellers try to cover their positions at the same time, it can quickly drive up the price even further. This phenomenon is known as a short squeeze.
Usually, news in the market will trigger a short squeeze, but sometimes traders who notice a large number of shorts in a stock will attempt to induce one. This is why it?s not a good idea to short a stock with high short interest. A short squeeze is a great way to lose a lot of money extremely fast.
The final and largest complication is being right too soon. Even though a company is overvalued, it could conceivably take a while to come back down. In the meantime, you are vulnerable to interest, and being called away.
Academics and traders alike have tried for years to come up with explanations as to why a stock?s market price varies from its intrinsic value. They have yet to come up with a model that works all the time, and probably never will.
However, you need to be aware that not only does short selling present an opportunity to generate tangible gains, but also that there are signals of alert about when a stock is about to fall. This knowledge differentiates an astute and patient investor from an impatient and following-the-herd-investor.
