Investing Advice: How To Safely Short a Stock

by Options Sensei |

Over the years Tesla (TSLA) has been a bit of a widow maker to short sellers.  the stock has gained over 300 percent since 2013.  But even as the price rose, or probably because it rose, the short position continued to increase.  It is now one of most heavily shorted stocks out there, with over 25% of the float sold short; that’s some 35 million shares with a current value of $1.3 billion. Today’s investing advice will show you a more sustainable way to hold bearish positions.

The past week has been especially painful as a solid earning report pushed shares up some 10% to $340 and then yesterday’s double-barreled news of a $2 billion stake by Saudi Fund and Musk’s tweet regarding taking the company private has propelled it back towards all time highs near $380 per share.

I don’t know how this tale ultimately play ends, but there have been plenty of other companies that were ‘story’ stocks with crazy valuations, from Amazon to Netflix, that have mauled the bears.

But shorting stocks will always be attractive to a certain type of trader or investor as when they are right it can produce legendary trades and huge profits.   Sometimes it’s company specific like Enron or Worldcom, sometimes entire sectors like the or housing bubble.

So, how can one identify a short candidate and more importantly, establish a bearish position that doesn’t create unlimited risk?

For the first part I turn to Jack Schwager’s book Market Wizards. One chapter features Dana Glante explaining how she made double digit returns year after year from her short only trading strategies, even in bull markets.

Here are her red flags for identifying short sale candidates:

  • High receivables (large outstanding billings for goods and services).
  • Change of accountants.
  • High turnover in chief financial officers.
  • A company completely changing their core business to take advantage of a prevailing hot trend
  • A company blaming short sellers for their stock’s decline.
  • A very high P/E ratio
  • A catalyst that will make a stock vulnerable over the near term.
  • An up-trend that has stalled or reversed.
  • Stocks breaking below their 50-day moving average.
  • A high priced one product company with low barriers for competitors to enter and compete.

I think the first few, which focus on accounting issues or the actual business model, are the best reasons.  Valuation, as we’ve seen in the examples above, can stay sky high indefinitely, especially if the company is generating sufficient cash flow.

As far as capping your risk; simple, don’t sell the stock outright.  Instead use put options.   Just make sure to use an expiration date with sufficient time to let your thesis play out.  You know what they say about how the market can stay irrational longer than you can remain solvent. Follow this investing advice, and you’ll be safe from prolonged irrationality.

 Related: How Long Can the Bull Market Last? 

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