Spread Betting Tips for Short Selling

Have you heard about short selling or shorting? I have already gone through a short introduction to shorting and placing down bets in the introductory series but here I’m going to review some helpful tips for spread betting which I’ve mostly learned from experience.

Spread Betting and Shorting (Down Bets):

  1. Curiously only about 3% of spread betters actually short-sell company share prices (not good with falling prices!)
  2. Spread betters going short usually hold a position for a lot less than a long one. A spokesman for InterTrader said: ‘What we tend to see is that markets experience a sharp drop and then pull back. When traders sell short they are looking to catch the fall without subsequently giving back the profits.’
  3. Whenever a share price plunges from the opening bell in response to news, there is very often a bout of profit-taking around the half hour mark, reversing the chart direction. For that reason I usually bank my gains just before then, making a note of wherever the low occurs, and looking to possibly re-short if the price drops through that low again an hour later. Same in reverse with those that surge from the bell.
  4. Which companies to short: Companies where the original concept or model for the business or major product is broken, is in decline or going out of date, such a technology-based product where new technology is starting to replace it are all candidates for shorting. Other possible candidates include companies that have been over-hyped or are run by over-optimistic management.

Tips for Shorters:

  1. Research companies that are operating in markets with fierce competition and low barriers to entry and areas where companies have limited pricing power and where there is low customer brand loyalty. Identify weaknesses. Does the company have a flawed business model? Is it overvalued? Is it experiencing weakening growth? Is it facing more competition? Is it a capital-intensive business? Have the fundamentals changed (say structural challenges presented by new technological shifts)?…etc
  2. Try to identify the catalyst that is likely to drive the stock lower – weakness in the industry sector suggesting an upcoming profit warning or dividend cut or looming redundancies or downsizing programme or breach in banking covenants?…etc
  3. Choose companies where the fundamentals and technical analysis both suggest weakness. Things to look for include breaches of key support zones on the charts or a dismal trading update. It is dangerous to short a stock just because it looks overvalued – just like cheap stocks can always get cheaper so can expensive stocks remain expensive for longer than you can remain solvent.
  4. Look at companies whose shares are making new 52-week lows – this is an omen that further downward moves are to come. In such cases it is however important to place appropriate stop losses above the resistance level to protect against a recovery in the share price (guaranteed stop losses can also come in useful here to protect against the possibility of takeovers, corporate actions, buybacks, hostile bids, slippage…etc).
  5. Avoid companies that are about to announce scheduled news or results because of the abnormal risks – in these situations a stock price can gap significantly higher or lower at the start of the trading session. Also, it is usually better to short a company which you believe is about to issue a profit warning rather than to short a company which has recently warned – the logic behind this is of course that rumours and speculation on poor trading tends to weigh down on a share harder than on one whose share price has already collapsed and thus has already had its earnings forecasts downgraded by City analysts.
  6. Is the company overvalued? The most obvious indicator of a company’s health is the Price/Earnings ratio: is the P/E trading at 45 or more [this would mean that it would take you 45 years to recover your investment if the company continued paying dividends at the current P/E ratio of 40]. Secondly is the P/E ratio more than twice that of the company’s earnings growth rate? eBay for instance traded for years at a P/E ratio above 100. Investors believed that eBay ‘s high growth rate warranted a high P/E multiple. However, at its peak point in Dec 2005, eBay was trading at a mighty 170 times earnings. Its earnings growth rate of 75% justified a high P/E ratio, but 170 was just too much. Sometime after that eBay admitted that its growth rate was slowing and the stock price halved. The third hint to look for is when the P/E ratio is 50% higher than the industry average, or more than 50% higher than the company’s historic P/E ratio. A company’s share price is more likely to trade at the historic trailing earnings ratio so a company with a P/E over 50% than the company’s historic P/E ratio is more likely than not to fall back to the it’s ‘median’ ratio.
  7. Young, unproven companies with high market caps and a high degree of optimism surrounding the shares that have yet to make a profit are perfect targets for shorters. Take for instance the case of online video search company Blinkx Plc in January 2008. No profit, High Market Cap, Free Share issues, Volatile markets, Low confidence…. Selling into a share like this drives the share down, holders with free shares bank profits, weak holders sell, new buyers are wary, institutions sit tight until results and down it went…the company’s share price fell from a high of 28.50 in the beginning of January to 16.25 by January 21st. Other good candidates to look for are debtridden companies which are struggling to make interest payments with falling revenue or companies with high operational gearing such as hotels and supermarkets who have fixed costs so a 10% drop in volume can equate to an 80% drop in profit.
  8. Choose companies that are liquid – you need to make sure that you are able to easily enter and exit at any time. In most cases the spread firms will not let you short sell anything less than a 50 million cap. In my own trading I really don’t start shorting anything with a market cap of at least £500 million. Of course, when the times comes to exit a short trade the market cap may be very much lower.
  9. Plan the trade thoroughly – preferably you need to have pre-defined entry and exit points. And remember, never add to a short at a price higher than a previous short.
  10. It is vital to manage the risk and have a stop loss in place if the trade is not going your way as otherwise you have unlimited loss potential. For example a good rule of thumb would be to stop yourself of any trade where the stock rallies more than 3% above its 50-day moving average.
  11. For positions which you only intend to hold for a few days it makes sense to rely on technical analysis. Look for companies where the price action has just turned down following a period of steady incline or parabolic rise.
  12. Technical patterns to look for include moving averages, relative strength indicators and breakouts. For instance a popular way to identify a new downtrend is by using moving average crossovers. This is because when a short-term moving average (say 10-day moving average aka as the ‘fast’ moving average) crosses below a longer term slowing moving average (say 30-day moving average) most traders take this a new sell signal.
  13. Do follow the trend – you need to analyse the price movement for the past months – if there’s a market shock (say company issues a profit warning with dim future prospects) this is usually followed by a market slump (usually to the extent that its oversold), after which there’s a rally due to both short term buyers and short sellers having to buy in order to take losses. Then, it starts to go down again but not as sharply. When the old low is taken out stop losses will get taken out by those that bought and the market often very quickly recovers.
  14. Take care when moving from long positions to short position. The danger is that you can end up losing money on the reversal down and again on the reversal back up and that is to say nothing about the trade costs. Short trades need to be taken early in the retracement. If you leave them too late they will likely end up being losing trades. So as the retracement continues its better to add to existing profitable shorts only to the extent that you try to hedge losses from your longs. At this point in the cycle our short trades should be in place and we should be concentrating on where the best value long trades are going to come from when we get the next bounce back up. Then we should be concentrating on how to identify the bounce. Randomly guessing is not a strategy for going long again.
  15. It is much more risky to short companies in general bull markets than bear ones. Sounds obvious huh? But newbie traders often short shares after an upward breakout in price has occured expecting a correction on profit-taking. However, such corrections tend to be brief and timing such corrections poses considerable challenges which makes such trades very high risk. It is much safer to short companies in weak conditions than when everyone else seems to be on a buying spree. Similarly, it can be dangerous to short companies in roaring bull markets; the best you can aim for in such circumstances is to try picking companies with incompetent management or those hit with unlucky circumstances or declining industries.
  16. Likewise, don’t disregard cyclical factors; in the short term a badly-run company in a popular sector is more likely to outperform than a good company in a sector that is out of favour. Good economic growth tends to boost performance in cyclicals like airlines or engineering companies while in a slowing economy stable industries like retail or pharmaceuticals tend to be more in favour.
  17. Shorting the market leaders in a recession is generally a bad idea – the assumption here is that traders think that bad news generally will affect them first, since they are most widely known. But this is far from a good strategy – it is a much better strategy to short the most vulnerable, problem-laden companies you can find. Thereby it is generally a bad idea to short the FTSE unless you are doing it as a hedge as the FTSE is made up of the best companies in the UK.
  18. Study stock loan data on Crest to get an idea of the current short positions in the market. The daily updates will require a subscription but the monthly figures are available for free (see ‘Stock Loan Data’) and these figures should give you a good idea of which companies have been most heavily shorted. Avoid shorting companies which are already heavily shorted. For those who argue against short sellers being allowed Santander’s recent takeover bid for Alliance & Leicester Plc will come as something of a lesson. This is exactly the type of risk that ‘shorters’ take. Some £150M was probably lost in just a few minutes by funds betting on continued weakness, as the A&L stock was one of the most heavily borrowed stock on the block. The price opened some 40% to the good from the close on Friday (from GBP2.20 to well over GBP3.00) and nobody had a chance to get out. The stock rallied to well above the Santander offer even though the chances of a competitor bid appeared slim (although not impossible) as shorts were forced to cover at any price. Remember also that lenders can withdraw or change stock borrowing terms which can force shorts to buy back in the market and cover their positions.
  19. Personally I tend to go short on stocks already declining. Other folk target risers they think are overstretched or due a correction or which have breached some chart signal indicating that – or which have an excessive p/e ratio or whatever. And some of them will just be plain wrong!
  20. With upbets and downbets on trending stocks, one strategy would be to start with a small stake so you can subsequently afford to place a wide-ish trailing stop loss which you could later tighten. If/when it moves into profit, sufficiently to allow not just a breakeven S/L but enough to cover the spread+stop loss on a second bet, you could open open a second bet, and so on.
  21. Companies on AIM tend to issue fewer shares than companies in the main market so are not usually attractive candidates for shorting. Also, it is not uncommon for founders and directors in AIM companies to own large shareholdings in these companies and the free-float tends to be low so taking a short position in these companies is quite risky. If the market moves against you there are only a limited number of shareholders to buy shares off to close a short position and thereby closing the short is likely in itself to drive share price up further. However, currently, and not surpisingly retailers, housing, pub, banks and leisure businesses are the most shorted sectors on the Alternative Investment Market (AIM). The FTSE 350 (comprising FTSE 100 and FTSE 250 companies) is a different story altogether with some retailers like Sainsbury’s, HMV and DSG International and property companies Persimmon and Bovis Homes currently having short positions exceeding 30 per cent.
  22. With shorting I want the opposite of buy low:sell high. So I look for relative strength to go short. My experience of shorting is that one is continually at the mercy of bounces so that if a short comes good I take the profits as soon as possible. This cost me substantial profits with Lehman, but I don’t mind leaving something for the next guy.
  23. History has proven that things like profit warnings are more likely to come in 3’s, therefore a company that issues 2 warnings in the space of a few months may well post a third warning. The third warning may never come but just keep this in mind.
  24. Even if shorting of financial stocks had been banned for sometime (short-selling ban on financial stocks has subsequently been lifted), creating synthetic short positions in an index heavy with financial companies provides an interesting alternative. This involves shorting an index and then going long on certain individual stocks within it to set up short positions in particular sectors such as financials.

Be warned that shorting is not for the faint-hearted -:

Buffett (who is a long term investor and doesn’t short stocks): ‘Charlie and I have agreed on around 100 stocks over the years that we thought were shorts or promotions. Had we acted on them, we might have lost all of our money, every though we were right just about every time. A bubble plays on human nature. Nobody knows when it’s going to pop, or how high it will go before it pops.’

‘Shorting is just tough. You must bet small. You can’t short the whole company. It takes just one to kill you. As it rises, it consumes more and more money.’

HIt is worth nothing that at the time of revising this article (March 2010) it appears that the markets are at a stage where fundamentals have started to weigh again. Bad shares go down in price while good shares go up which are good conditions for a trader!

Hopefully, the above shorting tips and strategies are useful to you, as they are to me, in fact I have made it a habit to re-read them every now and then – before you decide to start buying down bets it may also be useful to browse a number of short selling questions addressed in this section.

Market movements result from human nature, particularly those substantial swings driven by large fear or greed. So until human nature changes – don’t hold your breath – bull and bear markets will be with us, driven not by fundamentals in the main, but by emotion. When people feel good, the sky’s the limit. When they feel sick, there’s no telling how far the market can sink. Both cases overstate the true underlying nature of the scene.

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