Reasons To Short Stocks

I was recently asked by a Mostly Money Musings reader about reasons that I would look for in order to consider shorting a stock. Rather than just post a comment reply, I thought this raised an interesting thought for a regular posting.

Put simply, when an investor goes long on an investment, it means they have bought a stock believing that its price will rise in the future. Conversely, when an investor goes short, they are anticipating a decrease in the share price.

Shorting is the process of borrowing a security, then selling it with the belief that it will fall in value so you can buy it back at a lower price before returning it to its rightful owner. The security will be loaned to you by your brokerage, either from their own inventory or from another client. It will be sold and the proceeds credited to your account, and after a time you will be required to buy the shares back and return them. A lot of the time, you can hold a short for as long as you want. However, you can be forced to cover if the lender wants the stock back for any reason.

The key difference between going long and going short is the potential loss in each case. If you go long, your potential for loss is limited solely to the money invested in the stock should its value fall to zero. If you go short, your potential for loss is unlimited, since the price of a security can (in theory at least) rise forever. In practice, this does not happen, however a shorted stock can easily rise enough to wipe somebody out! I'm sure that many short sellers lost their shirts during the technology stock bubble.

So, why short any stocks at all? The most common reason to short is to profit from an overvalued stock or market, although some will use shorting as a means of hedging - to protect their long positions.

What should you look for when considering a short sale? I believe that the most important factor to look at is deteriorating fundamentals. Ultimately, it is strong fundamentals that cause a stock price to rise, as they are the foundation of a company or market, conversely deteriorating fundamentals damage the foundations of the company or market.

In particular, you may wish to consider factors such as rising debts, rising inventories, falling sales and revenues, over-valuation. You may also wish to look for outdated technologies, companies that fail to keep up with the times. You may wish to consider the effects of changes in management or keep a watch on the amount of insider ownership.

In addition to looking at deteriorating fundamentals, it also pays to look at technical factors too, as they offer a clue that all the buyers have bought and there is no-one left to hold up the security. In this case, a price drop would be expected, and a short sale could be possible.

Disclosure: At the time of writing the author did not hold any short positions.