Most investors by nature will "go long" when they buy stocks. Few investors naturally will short stocks (or bet on their decline) because they really don't know what to look for. Some investors see the shorting process as somewhat counter-intuitive to the traditional investing process, since many stocks do appreciate over time. That said, there is a lot of money to be made by shorting, and in this article, we'll give you a list of signs that show when a stock might be ripe for a fall.
Look at a chart of the stock you are thinking about shorting. What is the general trend? Is the stock under accumulation or distribution?
It is not uncommon to see a stock that has been in a downtrend continue to trade in that same pattern for an extended time period. Many traders will use various technical indicators to confirm the move lower, but drawing a simple trendline may be all that is needed to give a trader a better idea of where the investment is headed.
As you can see from the chart below, the declining trend will make it difficult for an investor to gain on a move higher, because the position will need to fight against the major underlying trend, which in this case is downward.
Other technical indicators, such as a moving average, can also be used to predict a downtrend. Many traders will watch for an asset's price to break below a major moving average to suggest a likely decline, because stocks that fall below a major moving average, such as the 200-day moving average, typically continue their descent.
Estimates Ratcheted Down
When a company misses its quarterly earnings estimates, management will usually try to explain to investors what happened in a conference call or a press release. Following this, Wall Street analysts work to compose a report and distribute it to their brokers. This process can often take a great deal of time - sometimes hours or days - which feels like an eternity in Wall Street chronology.
Astute traders will often aim to short a stock somewhere between the actual release and the time it takes the analyst to generate the report. Keep in mind that when the brokers receive these reports, they are likely to be moving their clients out of the stock, or at the very least reducing their positions.
Tax Loss Selling On the Horizon
In the fourth quarter, you will note that companies trading in the lower end of their 52-week trading range will trade even lower. Why is this? It is because individuals and mutual funds want to book some of their losses before year-end to reap the tax benefits. Therefore, these types of stocks may make good candidates for traders seeking to profit from a move lower.
There are plenty of reasons why an insider might sell his or her stock. This may include buying a home, or simply a desire to book some profits. However, if a number of insiders are selling the stock in large quantities, it may be a wise move to view this as a harbinger of things to come. Keep in mind that execs have extraordinary insight into their companies. Use this information to your advantage and time your short sales accordingly.
You don't need to find a company that is on the verge of bankruptcy to successfully short its stock. On the contrary, you need to see only a mild deterioration in a company's overall fundamentals for big holders of the stock, such as mutual funds, to get fed up and dump the shares.
Look for companies that have declining gross margins, have recently lowered future earnings guidance, have lost major customers, are getting an inordinate amount of bad press, have seen their cash balances dwindle or have had accounting problems. Put another way, investors need to be aware at all times of the "cockroach theory." That is, where there is one (problem), there is probably a whole bunch more.
Swelling Inventories/Accounts Receivables
This fits in under the topic of deteriorating fundamentals, but it stands to be emphasized because these are two of the most obvious (increasing inventories and accounts receivable) signs that a company is going downhill.
What do these figures tell you?
Increasing inventory figures might not be a bad thing if a company has recently launched a new product and is building up a backlog of that product in anticipation of selling it. However, if a company shows a sizable inventory jump for no reason, it is a sign that it has goods on its books that are stale and might not be salable. These, in turn, will need to be written off and will have an adverse impact on earnings down the line.
Increasing receivables is a bad sign because it indicates that a company isn't being paid by its customers on a timely basis. This will also throw off earnings going forward. If some of these debts ultimately prove to be uncollectible, they will also have to be written off at some point.
Declining Sector Trends
While a company will occasionally buck a larger trend, most companies within a given sector or industry trade in relative parity. That means that supply and demand issues facing one company are likely to impact others at some point down the road. Use this information to your advantage. Make phone calls to a company's suppliers and/or customers. They can confirm whether the company is witnessing the same problems (or opportunities) as other players in the same industry or sector.
Investors need to be aware not only that short selling presents an opportunity to generate tangible gains, but also that signals can alert an investor when a stock is about to take a fall. This knowledge will make you an immeasurably better investor.
Options & FuturesThis strategy allows you to stop chasing losses when you're feeling bearish.
Fundamental AnalysisThis strategy can help in market downturns, but it's not for inexperienced traders.
Options & FuturesThe media demonizes naked short selling, but in most cases it occurs in a collapse, rather than causing it.
Options & FuturesThis controversial strategy is blamed for making and breaking markets. Read on to learn more.
Active Trading FundamentalsIf more people understood short selling, it would invoke less fear, which could lead to a more balanced market.
Active Trading FundamentalsWant to profit on declining stocks? This trading strategy does just that.
RetirementWe discuss the advantages of seeking professional help when it comes to managing our retirement account.
ProfessionalsLearn what a typical early morning to late evening workday for a hedge fund manager consists of and looks like from beginning to end.
Investing NewsThe force is strong with Disney stock, as it continues to make gains going into the launch of EP7. But is this pricey stock a good buy at these levels?
Mutual Funds & ETFsThese Schwab funds are strategically designed and have performed well on a historical basis, meaning they're solid options for retirement.
Swing trading is a popular investing strategy because it yields faster results than typical buy-and-hold strategies without ... Read Full Answer >>
A short position and a short sale are very similar concepts; for this reason, they are often collectively referred to as ... Read Full Answer >>
There are several key differences between working capital and fixed capital. Most importantly, these two forms of capital ... Read Full Answer >>
Variable annuities are subject to the ups and downs of the market, so they do not guarantee returns of principal. To mitigate ... Read Full Answer >>
Since 2008, when the Federal Reserve slashed interest rates to zero and then kept them there indefinitely, dividend-paying ... Read Full Answer >>
Hedge funds use several forms of leverage to chase large returns. They purchase securities on margin, meaning they leverage ... Read Full Answer >>