The Reaper’s Guide to Short Selling Stocks

The point of this article is threefold: to associate the nickname “The Reaper” with me and my short selling activities so that when I become as famous as Jim Chanos or Manuel Asensio or at least Andrew Left, I can appear on the cover of Forbes magazine wielding a scythe (see picture below); to inform investors about short selling so that they realize the folly of buying into stocks just because of a so-called “short squeeze”; and to inform those crazy enough to actually try short selling about different strategies for doing it.

There are a number of websites dedicated to finding stocks that are prone to a short squeeze and recommending that traders buy those stocks. A short squeeze can occur under two different but similar situations. In each case, there is widespread negative sentiment about a stock in which short sellers have sold short a large percentage of the outstanding shares of the stock (leading to a high short interest ratio). In one case, routine speculative buying on the part of traders pushes up the price of the stock, which creates losses for the short sellers and this may lead some of them to cover their short positions (buy back the shares they borrowed and sold), and this buying on the part of the short sellers drives the stock price up even further.

The other case is where some good news comes out about the company which leads to the same outcome. In this case, a quick witted daytrader or momentum trader can easily make a lot of money. The trader might see the headline and quickly buy the stock at the same time the quickest shorts start covering, and by the end of the day there can be a whole lot of profit as mounting losses cause most of the other shorts to cover as well. I found myself on the wrong end of this kind of short squeeze in early February 2007 with Onyx Pharmaceuticals [[ONXX]] (see chart of squeeze). The market expected poor results from a drug trial, but the company reported outstanding results. Considering that the drug in question was one of only a few that the company was developing, this was incredibly good news for Onyx. Shares doubled from $12 to $24 in one day. I was quick and got out of my short position in the stock with only a 50% loss. A quick witted trader could have read the same headlines I read and bought as I was covering and realized a 30% profit in one day. Of course, I do not recommend such daytrading because most people are very bad at it, but I do recognize that some people do it well and they serve a purpose in the markets.

Non-news-driven short squeezes are much different despite looking very similar on the price charts. The problem with this kind of short squeeze is that there is no fundamental reason for the stock price to go up. As I have previously written (and written elsewhere), stocks targeted by short-sellers tend to do worse than the market as a whole, and people who buy a stock just because the short interest is high and just because there’s a possibility of a short squeeze would do well to remember that. Another thing to keep in mind is that if a company is bad enough, the short-sellers are very strongly convinced of their negative opinion of the company, and the short sellers have deep pockets, there is no reason why the short sellers need to cover just because of a temporary increase in the stock price. A good example of this is the various price increase in the stock of Home Solutions of America [[hsoa]]. The critics of the company are convinced that it is both fraudulent and insolvent and that the stock is worth nothing. So they will likely just hold onto their short positions and grit their teeth to withstand the short-term losses because they believe that within a few months or a year they will be sitting on a 100% profit.

Now, because I am a reasonable and conservative person, I feel obligated to warn you that short selling is highly dangerous, speculative, and for most people it is simply dumb to do it. In fact, we expect the return from selling short stocks to be about -10% per year because on average that’s about how much stocks go up per year. So unless a short seller has a lot of time, talent, guts, and knowledge, he or she should expect to lose money over time.

Short Selling for Fun and Profit

The one rule of short selling is this: don’t do it. If you ignore the rule you deserve what you get, whether it be fortune (if you have great talent and good luck) or poverty (if you have modest talent or great talent and bad luck). Consider yourself warned.

Now that we have that out of the way, there are two ways to profit from short selling stocks: momentum shorting and what I call steel-gut shorting.

Momentum shorting

As mentioned above, selling on negative news can be profitable. It is hard to tell what will continue to fall and what will bounce back. There are a few strategies to use. I have tried using certain influential blogs as my ‘news’ sources.

I receive emails of updates to those blogs or see the postings within an hour of them being published because I subscribe via RSS and I check my RSS reader often. If I see a negative comment about a stock I can quickly check to see if I can short it and then I can quickly short sell it.

This strategy has been a mixed bag and I have probably broken even. While Terra Nostra Resources (OTC BB: TNRO) gave me a nice profit, and Uranerz [[urz]] gave me a respectable profit, I saw small losses on several others, including Cellcyte Genetics (OTC BB: CCYG).

Steel Gut Short Selling

Imagine selling short a worthless company only to see the market double or triple its market value. You hold on. No–you don’t just hold on. You sell more. You borrow money and sell more. The company approaches a valuation that is absurd and crosses it. You sell more. You take out a loan against your house and you sell more. You borrow from friends and sell more. You sell your car and your house and you sell more of the stock. If the stock returns to only modestly overvalued you will make a fortune. If not, you lose everything.

This story ends in a couple ways. If you were unlucky and sold short Amazon.com or Yahoo or Lucent or any other overvalued tech stock in 1998 or 1997 then you were ruined. If you sold short in late 1999 or 2000 or 2001 then you made a fortune.

There are a few keys to making this work. First, be diversified in time and in stock. Make sure that no loss, no matter how incredible, will put you out of business. Second, stay liquid. Don’t get anywhere close to your margin limit. Have some backup cash or a credit line ready so that if the stock shoots up you can wire in some more money and short more. Third, don’t short a stock unless there is something that will force it down. In other words, don’t go against stock momentum or bet against a ‘high-tech’ company, even if the product is a rumor and the company’s sole asset is a promise and a ‘vision’. At the very least, if you do that, make sure that it is a small part of your overall portfolio.

At the risk of repeating myself I will repeat myself: do not short stocks that are valued at a multiple of promises and dreams. My only significant losses in short selling have come from Research Frontiers [[refr]], Document Security Solutions [[dmc]], and Parkervision [[prkr]]. None of these companies has an operating business worth more than 10% of its market cap. Parkervision and Research Frontiers have great new technologies (that I think are totally bogus) and Document Security Solutions has a patent and a court case. If you take a look at Research Frontiers, you will find that it has been promising for decades that its great technology is just around the corner, and yet it never seems to sell anything (see my previous article on Research Frontiers).

Even after avoiding stocks that sell at a multiple of hope, it is important to avoid companies where there is no clear reason why the stock should go down in the short run. Short sellers of Imergent [[iig]] and Usana [[usna]] would do well to remember that. The sad fact is that companies with a bad business can last far longer than they should.

So what is left to short? There are wildly overvalued stocks that are overvalued only because no one knows about them. This is the type of stock that Continental Fuels (OTC BB: CFUL) was. I sold it short around $2.70 and rode it all the way down to $0.50. It is now trading at $0.60. When I shorted it, its diluted market cap was over $1.5 billion and yet it had maybe $10 million in sales, no promising technology, and a negative book value. However, it is very tough to find such stocks, and getting ahold of their shares to short is very hard.

Then there are the fading stars. These are once-highflying companies that run into problems and have little hope of evading them. Examples include Vonage [[VG]] and Krispy Kreme [[kkd]]. Krispy Kreme I just missed, while by the time I became active in shorting, Vonage was too cheap. This is also the category into which most housing-related stocks would fall. Everything from Countrywide [[CFC]] to New Century Finance (now bankrupt) to DR Horton [[dhi]] and E*trade [[etfc]] (didn’t realize they had a big mortgage operation, did you?). [Note: amusingly enough, when I first wrote about E*trade as a short it was weeks prior to its recent stock market crash. I did not actually short it, though it would have been quite profitable to do so.]

Trends, no matter what kind, tend to last longer than anyone thinks. So if you had waited until after the first mortgage problems had made themselves evident in January and February and after panic subsided, you could have shorted a large number of financial and house-building stocks at attractive prices.

If you short sell, good luck. If not, good luck. But even if you do not short sell it would behoove you to pay attention if short sellers target your favorite stock. Imagine the happiness of those few Enron shareholders that sold after hearing about Jim Chanos’ shorting of the stock.

Disclosure: I have no position in any stock mentioned. My disclosure policy makes for good reading. The picture of the grim reaper above is me. Yes, I do realize that I need to sharpen my scythe. No, I do not take myself too seriously.

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