Article

When to Short a Stock

Most investors by nature will “go long” when they buy stocks. Few investors naturally will short stocks (or bet on their decline) because they really don’t know what to look for. Some investors see the shorting process as somewhat counter-intuitive to the traditional investing process, since many stocks do appreciate over time. That said, there is a lot of money to be made by shorting and, in this article, we’ll give you a list of signs that show when a stock might be ripe for a fall.

Technical Trends
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 not uncommon to see a stock that has been in a downtrend continue to trade in that same pattern for an extended time period. Many traders will use various technical indicators to confirm the move lower, but drawing a simple trendline may be all that is needed to give a trader a better idea of where the investment is headed.

As you can see from the chart below, the 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.

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Fig 1 Short Sell – Source:- Metastock.com

Other technical indicators, such as a moving average, can also be used to predict a downtrend. Many traders will watch for an asset’s price to break below a major moving average to suggest a likely decline, because stocks that fall below a major moving average, such as the 200-day moving average, typically continue their descent.

Estimates Ratcheted Down
When a company misses its quarterly earnings estimates, management will usually try to explain to investors what happened in a conference call or a press release. Following this, Wall Street analysts work to compose a report and distribute it to their brokers. This process can often take a great deal of time – sometimes hours or days – which feels like an eternity in Wall Street chronology.

Astute traders will often aim to short a stock somewhere between the actual release and the time it takes the analyst to generate the report. Keep in mind that when the brokers receive these reports, they are likely to be moving their clients out of the stock, or at the very least reducing their positions.

Tax Loss Selling On the Horizon
In the fourth quarter, you will note that companies 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 types of stocks may make good candidates for traders seeking to profit from a move lower.

Insider Selling
There are plenty of reasons why an insider might sell his or her stock. This may include buying a home, or simply a desire to book some profits. However, if a number of insiders are selling the stock in large quantities, it may be a wise move to view this as a harbinger of things to come. Keep in mind that execs have extraordinary insight into their companies. Use this information to your advantage and time your short sales accordingly.

Fundamentals Deteriorating
You don’t need to find a company that is on the verge of bankruptcy to successfully short its stock. On the contrary, you need to see only a mild deterioration in a company’s 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, are getting an inordinate amount of bad press, have seen their cash balances dwindle or have had accounting problems. Put another way, investors need to be aware at all times of the “cockroach theory.” That is, where there is one (problem), there is probably a whole bunch more.

Swelling Inventories & Accounts Receivables
This fits in under the topic of deteriorating fundamentals, but it stands to be emphasized because these are two of the most obvious (increasing inventories and accounts receivable) signs that a company is going downhill.

What do these figures tell you?

Increasing inventory figures might not be a bad thing if a company has recently launched a new product and is building up a backlog of that product in anticipation of selling it. However, if a company shows a sizable 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 at some point.

Declining Sector Trends
While a company will occasionally buck a larger trend, most companies within a given sector or industry trade in relative parity. That 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. Make phone calls to a company’s suppliers and/or customers. They can confirm whether the company is witnessing the same problems (or opportunities) as other players in the same industry or sector.

In Summary
Investors need to be aware not only that short selling presents an opportunity to generate tangible gains, but also that signals can alert an investor when a stock is about to take a fall. This knowledge will make you an immeasurably better investor.

Glenn Curtis is a freelance financial writer and analyst contributing to the likes of Investor’s Business Daily, The Washington Times, Forbes and CNN

Glenn Curtis started his career as an equity analyst at Cantone Research, a New Jersey-based regional brokerage firm. He has since worked as an equity analyst and a financial writer at a number of print/web publications and brokerage firms including Registered Representative Magazine, Advanced Trading Magazine, Worldlyinvestor.com, RealMoney.com, TheStreet.com and Prudential Securities. Curtis has also held Series 6, 7, 24 and 63 securities licenses.

As a freelance financial writer and analyst, Curtis has also been quoted in a variety of trade publications and venues including Investor's Business Daily, The Washington Times, Forbes and CNN.

Dr. Toad

Active member
Jul 21, 2015
169
33
38
#2
Glenn missed one of the most important (but easily overlooked) aspects of what to look for when shorting a stock. This is --> how easy it is to short the stock. I can't even count the number of times I have tried to short a stock only to have my order rejected since my broker has no shares to short (and I am with a fairly major broker).

If it is an obvious candidate to short that is not an easily borrowed stock, you will be SOL. This has happened to me so many times I don't even bother looking for or trying to develop strategies around shorting stocks. My broker has a list of easily borrowed stocks, and I suspect most do. If developing a strategy around this, you will need to reduce your list of candidates to what they have which tends to be major corporations that are less likely to have the sharp extended downtrends that smaller corporations can experience.

Not saying there are no opportunities there, just that the pool you are playing with is comparatively small. Especially if it is an obvious candidate to short, it will be hard to execute the trade when your signal is triggered which is extremely frustrating. When shorting, you are truly at the mercy of your broker which is a bad positions to begin a trade at.
 

sminicooper

Well-known member
Jun 13, 2016
1,140
321
93
#3
Glenn missed one of the most important (but easily overlooked) aspects of what to look for when shorting a stock. This is --> how easy it is to short the stock. I can't even count the number of times I have tried to short a stock only to have my order rejected since my broker has no shares to short (and I am with a fairly major broker).

If it is an obvious candidate to short that is not an easily borrowed stock, you will be SOL. This has happened to me so many times I don't even bother looking for or trying to develop strategies around shorting stocks. My broker has a list of easily borrowed stocks, and I suspect most do. If developing a strategy around this, you will need to reduce your list of candidates to what they have which tends to be major corporations that are less likely to have the sharp extended downtrends that smaller corporations can experience.

Not saying there are no opportunities there, just that the pool you are playing with is comparatively small. Especially if it is an obvious candidate to short, it will be hard to execute the trade when your signal is triggered which is extremely frustrating. When shorting, you are truly at the mercy of your broker which is a bad positions to begin a trade at.
Good points. I like shorting stocks because when they go, they go. It's not normally a problem with IG (ok – they do make their own market). But even with them on occasion, if there is a particularly obvious opportunity (to me, at least!) they sometimes don't provide the facility. Occasionally they will also not offer controlled risk (guaranteed stop) which forms an important part of my risk strategy. But neither of these happenings is a problem – just move on to other fish in the pond. It's no more annoyance than routinely checking earnings/dividends/XD dates.