by Michael Sanibel

Created on: September 24, 2008   Last Updated: October 23, 2008

Strategies for Shorting Stocks: Risks and Rewards.

Shorting stocks takes a certain amount of courage since you are betting against the long-term trend. History tells us that. But pure gambling on stock direction has no place for successful investors when you consider that there is really no limit to your loss potential on a short position that goes the wrong way. Therefore, the key is to focus on the short-term trend and to minimize your risk by finding stocks that may be under selling pressure for any number of reasons, whether factual or not.

The best starting place is usually to find sectors of the economy or specific industries that are experiencing economic duress. During the past few years, companies involved in the housing industry and investment banking have taken severe hits due to the housing bubble implosion. The American automakers have also suffered from the rise in the price of oil, making it more difficult to sell trucks, SUVs, and other mainstays of their inventories. Other parts of the economy have suffered a ripple effect as these key components of GDP growth have stalled and reversed. Any of these were good candidates for short selling of their stocks.

One way to scour the landscape searching for short candidates is to look at chart trends and technical indicators. One important signal for shorting is to determine if a stock has broken below key support levels and moving averages. Such a break can be one sign that a stock is headed into a downtrend. Technical analysis of chart patterns can also reveal likely short scenarios, such as when a stock forms what is called a double-top. This type of formation occurs when a stock peaks, then retreats and makes another stab at the peak. If the stock begins to decline after achieving a level at or near the first peak, there is a reasonable chance that it will continue to decline until it finds a previous support level.

One of the dangers of shorting is getting caught in what is commonly referred to as a "short squeeze." This can occur for a variety of legitimate reasons such as a bullish news announcement, but it can also be based on rumor and outright false information. When demand for a stock suddenly outstrips the available supply, the price can be forced higher very rapidly. This is more likely to happen in stocks with smaller market capitalizations and share floats. The price rise can feed on itself as more short sellers cover their positions by buying back the stock, causing even more upward movement. At the first sign of a squeeze play, savvy investors will most often get out of the stock before an upward price cascade sets in.

Shorting requires you to do something that may look easy, but may not be that easy for some people. To maximize your profit, you need to hope that the company will fail miserably and sink deeply into debt. You want the stock to tank uncontrollably and for the company to go out of business. The more horrible the news is about the company, the better you like it. Deep in your heart, you are praying for a worst-case scenario that will yield you great rewards. For these reasons, many believe there is something un-American about shorting and some believe it should be prohibited completely. They despise the concept of having investors helping to bring about lower stock prices by selling stocks that they don't already own. They think that short sellers should have no place in the marketplace.

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