When to Short a Stock

Most investors by nature will "go long" (buy stocks). Few investors naturally will short stocks (bet on their decline), often because they don't know what to look for. Some investors see the shorting process as somewhat counterintuitive 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.

Key Takeaways

  • Stock shorting—investing in stocks on the bet that they will fall—can be intimidating to investors who are used to the more traditional approach of buying securities that they expect will rise over time.
  • There are technical trends that many short sellers monitor, including using a simple trendline or a moving average to note a downtrend or other opportunities to take advantage of stock fluctuations.
  • If a company reports quarterly results or gives a profit forecast that is less than expectations, there is often an immediate decline in the stock, ashort s quick-moving sellers move to short the stock.
  • Other techniques that can tell an investor when it's time to short include tracking seasonal factors such as tax-loss selling, insider moves, declining fundamentals, and sector weakness. 

Technical Trends

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.

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 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 often trade even lower. This 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 toward the end of the year.

End-of-year tax-loss selling and other seasonal trends are useful for investors to monitor as there are often opportunities at select times of year to short certain stocks.

Insider Selling

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.

For most investors, short selling should only be one part of an overall investing and wealth management strategy that includes portfolio management, diversified holdings, short-term and long-term funds and ETFs, and other investments, such as real estate.

Fundamentals Deteriorating

You don't need to find a company that is on the verge of bankruptcy to successfully short its stock. Sometimes 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.

Inventories/Accounts Receivables

This falls under the topic of deteriorating fundamentals, but it stands to be emphasized because increasing inventories and accounts receivable are two of the most obvious signs a company is going downhill.

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 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 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 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.

The Bottom Line

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.

Investopedia does not provide tax, investment, or financial services and advice. The information is presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Investing involves risk, including the possible loss of principal.

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