MONEY MATTERS
SHORT SELLING
BY RICH TEJIDOR

I prefer buying under-valued stocks to short selling because the risk is lower and the payoff can be higher. But under-valued stocks have been an endangered species for several years, so my focus has been almost exclusively on short selling. 

When you short sell a stock, you can lose several times the share price of the stock if things get out of hand, i.e., if the price of the stock skyrockets. In addition, the most you can earn is a 100 percent return if the stock falls to zero, unless you short additional shares as the price falls. 

This is in contrast to long positions, also known as a regular stock purchases, where the upside potential can be several fold and the most you can lose is 100 percent of your investment. 

When I look for short selling recommendations, I primarily focus on companies that burn cash or have failed business models. Instead of relying on net profit as an indicator of cash burn, I also look at whether a company has a negative cash flow from operations (CFFO). 

I do this because if a company has a positive cash flow from investment or financing activities, it can overshadow the negative CFFO and result in a positive net income, which makes the company look healthy. However, if a company has a negative CFFO, especially for several quarters, there is usually something seriously wrong with the company.

If I find a company with severe cash burn, I won’t consider shorting it unless the price has already started to break to the downside. This is because shorting stocks with a price uptrend is like “trying to shoot cougars out of trees,” as short seller Marc Cohodes likes to say.  Basically, you want to minimize the risk of getting mauled. 

Another factor I consider is analyst opinion. Positive buy recommendations are a dime a dozen. However, a sell recommendation usually indicates there’s something really wrong with a company. Outright sell recommendations are pretty rare, so I also look for numerous analyst recommendation downgrades.

When you short a stock, it’s always important to hedge the position to limit your upside exposure. I recommend using buy-stop orders or call options.  A buy-stop order is a broker order to cover your short position by buying shares at a certain price. Each call option gives you the right to buy 100 shares at a predetermined price and expiration date. 

Call options minimize risk more than buy-stop orders because, even though you may have an order at a specific price, it’s still possible that you may be unable to execute your order at the desired price. This is especially true during violate price upswings, which can result in a greater than anticipated loss. 

I don’t make specific recommendations on whether to use a buy-stop order or call options or at what prices to set the orders or buy the options at because these are dependent on the investor’s individual risk profile. Some people can only tolerate a small increase in share price. Others can stick through much larger increases while waiting for the payoff. 

Short selling isn’t for everyone. If you can’t stomach the extra risk, it may be better to stick to regular stock purchases, money market funds, or certificates of deposit. LW