How to sell stocks short profitably

Short selling is a practice with a bad name. In times of financial crisis, regulators and governments take aim at short sellers as pirates only out for themselves. But in reality short sellers face far greater risks and as a result practictioners tend to be some of the most financially savvy and literate investors in the market - often acting as 'policemen' against financial shenanigans. By learning some tricks to highlight good candidates for short selling the practice can possibly enhance your returns and lower your portfolio volatility.

What is a short sale?

Short selling is the practice of selling borrowed shares in order to buy them back at a cheaper price when the share price falls thus bagging a profit. Short sellers don't own the shares they sell, so they need to borrow them for a fee from a current shareholder.

The profit/loss equation for short sellers is very different to owning shares. When short selling your maximum gain is capped at 100% if the share price falls to zero, whereas the potential loss could be infinite as share prices can theoretically rise indefinitely.

Shares also need to be borrowed from owners before a sale can be made meaning that short sellers also face ongoing interest costs. These costs make it absolutely vital that short sellers only enter positions when the timing is perfect as it can be a very expensive business when it goes wrong.

How short selling can improve your returns

Ever since the dotcom bubble burst in 2000, equity investors have been subject to a dirty dozen years of volatile sideways markets. In this time there have been 2 great bear markets providing vicious swings to the downside and great opportunities to short sellers.

In sideways markets with deflating credit conditions the traditional philosophy of buy and hold is shortsighted and smart investors hedge their long portfolios with a smaller proportion of short sales. Strategies such as 130:30 which add a 30% leverage to a long only portfolio in order to short the market are becoming more popular amongst fund management community providing greater upside potential and downside protection.

The art of a smart short sale

While high P/E ratio stocks have been shown to underperform low P/E ratio stocks, in the long run high P/E stocks still have had **positive returns**. In other words shorting high valuation stocks isn't necessarily a profitable strategy!

But that's what many short sellers do - going after high P/E 'glamour' stocks that they feel are too highly valued by the market - time and again they lose their shirt to the fact that the market prizes its 'stars' on ever higher ratings.

A short seller needs a quantifiable edge and the odds can only be swung in his favour by shorting stocks that are not only highly valued but also amongst the financially weakest in the market. 

How to find financially weak companies - 3 Shorthand Red Flags

While forensic accounting and credit analysis are beyond the ability of most individual investors, there are some excellent short cuts that have been developed by professors of finance to highlight high risk shares. Our research and reading in the area have uncovered the following three red flags that every investor should understand to narrow the universe of potential short sales.

1. High Bankruptcy Risk - the so called 'Altman Z-Score' is a scoring system developed by Prof. Edward Altman in the 1970s to highlight companies with a significant risk of financial distress. Companies with a Z-Score < 1.8 have been shown to have a 75% risk of financial distress within 2 years. Obviously when companies go bust their share price goes to zero making them keen short sale candidates!

1. High Earnings Manipulation Risk - glamour and growth are alluring not only to investors but also to company management whose compensation is dependent on a continuation of the trend. Accounting tricks such as booking sales early, changing depreciation rates and so on are all available for managers to massage earnings figure. The Beneish M-Score was developed to highlight these companies. An M-Score > 2.22 highlights companies that may be inflating their earnings artificially increasing the likelihood they will have to report lower earnings in the future.

1. Poor financial health trend The now very renowned Josef Piotroski came up with his 9 point scoring system in order to figure out which of the cheapest companies in the market were most likely to recover. The so called F-Score spans nine tests of changes in profitability, efficiency and leverage from year to year which highlight improving or declining financial health trends. James Montier and others have found that glamour stocks with F-Scores < 3 and poor capital discipline make good short sale candidates.

By focusing your short selling activities on the small group of stocks in these baskets, you can significantly increase your odds of turning a profitable short sale.

Enhancing returns with Technical Analysis

The final piece of the short selling puzzle is to understand the optimal technical timing of a sale when a stock is due to roll over. The best brief on the subject was published by Bill O'Neil - founder of Investors Business Daily - 'How to Make Money Selling Stocks Short'. Essentially O'Neil states that the best time to short a stock is when it is struggling to recover back from a fall beneath its 50 day moving average. If attempts to rally back above the 50 day MA fail on multiple occasions on weakening volume you may have found the best time to lay on a short.  Further information for technicians is available at the link.

What kind of returns can you expect and where can you find ideas?

The average stock in James Montier's short selling strategy mentioned above fell by 8% per annum over a 22 year period from 1985 to 2007. The M-Score used in tandem with some other indicators to create a compound O-Score was found to predict price declines of 25% p.a. while the Z-Score has been shown to predict companies going into financial distress with a 75% success rate.

If you are looking to find good short selling candidates you can find lists of stocks qualifying for these indicators at the screening tools available at Stockopedia Premium.    We print the three indicators mentioned above on all of our Stock Reports providing you not only with greater short selling confidence but also greater clarity for when you should sell your longs.

Investors should always beware the risks of short selling mentioned above, and understand that trading baskets of financially weak shares is the most optimal way to harvest the returns available in this area.