How to Pick Short Stocks
Shorting stocks is the reverse of buying stocks. Instead of buying low and selling high, the goal is to sell borrowed shares high and later buy low to cover the original loan. Picking stocks to sell short is basically the inverse of picking stocks to buy, and there are several different methods. Fundamental investors look to companies whose earnings or growth potential has reached a limit. Value investors look for stocks whose prices have risen too high too quickly. Technical traders look at stock graphs which, for a variety of reasons, indicate a decline in prices. The most successful investors tend to incorporate aspects of all these approaches.
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Instructions
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Examine fundamentals. Look at the company's financial statements and listen to their conference calls to get a sense of how the company earns its revenue and whether the business model is sustainable. Classic examples of fundamental shorts are newspaper companies and TV networks at the dawn of the digital age of online advertising. Also consider whether the company is likely to lose market share to competitors, as occurred in the microchip industry as fabrication became more standardized.
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Check valuations. Use a stock research tool such as Yahoo! Finance to compare price-to-earnings (P/E) ratios of stocks in the same industry. The "best in breed" company will typically have a higher ratio than the others. Because P/E is forward looking, use knowledge of fundamentals to determine when a stock is overvalued. For example, most "dot com" stocks were overvalued in 2000 largely because analysts valued them according to page visits rather than actual revenue. The following bust was simply a reversion to rational valuation levels.
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Graph technicals. Stock graphs are frequently used to determine when a stock has "topped," or reached a level after which prices should decline. Many more technical indicators can be described here, but it is rewarding to learn at least a few basic ones, such as RSI, MACD and moving averages. More advanced techniques such as candlestick recognition and Elliott wave-counting require considerable practice and some training.
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Check short interest. Don't short a stock if too many traders already have shorted ahead of you. The short interest can be obtained from advanced stock tracking platforms. When too many have already shorted (a high short interest), stocks are prone to what's called a "short squeeze," which occurs when shorts buy to cover in a frenzy that sends a stock price significantly higher.
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Tips & Warnings
Technical indicators are usually best for choosing a trigger or execution point to time a trade. A fundamental or valuation thesis can be correct, but it might take weeks, months or years for your expectations to be released.
While a stock can go to zero, there is theoretically no limit to how high it can rise. This means there is no limit to how much can be lost shorting stocks. Losses can easily exceed your initial investment, especially because shorting typically requires trading on margin. Use a simulator such as Marketocracy to practice shorting for free before risking real capital.
