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Selling Short Can Backfire

I get a lot of mail asking me to describe a strategy for picking short-selling candidates. That mail has gone unanswered. Now I’m going to tell you why.

As you probably know, short-selling is a strategy for profiting when stocks go down, instead of up. Shorting stocks is an appealing strategy because, in theory, it is a way of making money in a weak market, which we’ve seen in abundance the last few years.

Here’s how it works.

Selling Short Explained
Short-sellers borrow shares from their broker that they don’t own and immediately sell the borrowed shares in hopes that they can buy them back later at a cheaper price.

For example, say you think that a stock currently selling for $60 per share is a good shorting candidate, and you sell it short at that price. Further, assume that you’re right and it drops to $35. Then you close the transaction by buying the stock at $35 to repay the loan. In effect, you bought at $35 and sold at $60. But beware; if you guess wrong, you can lose a lot of money in a hurry. For instance, if your $60 stock went up to $100 instead of down to $35, you would have lost $40 per share.

Recently I checked on the results of my latest stab at devising a short-selling strategy. The intention, of course, was to build a portfolio of stocks that would drop in value.

Here’s what happened.

Stocks Went Wrong Way
As of last week, since the May 15, 2005 portfolio formation date, instead of going down, my short candidates had gone up 17 percent on average, more than double the S&P 500 index’s 7 percent return. Two of my picks had more than doubled and six more had gained at least 40 percent.

What’s more, only ten of my 45 short picks had dropped, compared to 29 stocks that recorded gains. (the remaining 6 were unchanged).

That disaster was only the latest of a series of misadventures in my quest for an effective shorting strategy.

Quest for Shorting Strategy
When I started, a couple of years ago,
I tried picking stocks with weak fundamentals. For instance, I sought out stocks with debt-laden balance sheets, declining profit margins, and faltering sales growth. The results were unsatisfying. While some stocks did drop, as a whole, my portfolios performed more or less in tune with the overall market.

Then, I tested a sort of “anti-momentum approach.” Momentum players, at least as I define them, look for stocks where analysts are forecasting accelerating sales and earning growth. Momentum candidates must also have high relative strength, meaning that the stocks have already outperformed the overall market over the past year.

So my anti-momentum shorting strategy picked stocks with decelerating growth forecasts and weak price charts. That too yielded mixed results.

Finally, last May, I had an inspiration. Many professional short-sellers employ squads of analysts who spend their days scrutinizing financial statements and who knows what else to deduce which stocks are likely headed down. So why reinvent the wheel? Instead of trying to decode which fundamentals applied, I would simply piggyback on these short-seller’s efforts. That’s easily done.

The stock exchanges tabulate short-sales data once a month. You can see the data for any stock on the NASDAQ site. From NASDAQ’s home page (www.nasdaq.com) enter a ticker symbol, select InfoQuotes, and then click on Short Interest.

Short interest is the number of shares that have been borrowed by short sellers for their trades. Since the total number of share outstanding varies widely between stocks, short interest by itself doesn’t mean much.

The short-interest ratio is a better gauge because it compares the short interest to trading volume. Specifically, it’s the number of days it would take for the short sellers to buy back their borrowed shares, based on the recent average number of shares traded daily.

Short interest ratios typically run from zero to 20 days, and sometimes higher. The higher the ratio, the higher the short interest. There’s no specific dividing line, but, at least in my view, ratios of five and up signal significant interest from short-sellers (NASDAQ lists the short interest ratio as “days to cover”).

Screen Found Candidates
I came up with my short candidate portfolio using Reuters Knowledge, a pricy research tool used mainly by professionals, to screen for stocks with short interest ratios above seven. To insure that short-sellers’ interest wasn’t waning, I also required that the ratios must have increased at least 10 percent from the previous month. I added a few similar requirements to narrow the field to a reasonable number, specifically, the 45 stock portfolio that I mentioned earlier.

If you want to emulate my screen you can come close using Reuters’ free PowerScreener Lite at investor.reuters.com.

Puzzle
Why my screen found stocks that mostly went up instead of down is a matter of conjecture.

One reason might be short covering. By that I mean that when a shorted stock heads up, instead of down, short-sellers might buy back the shares they owe to close their transactions and limit their losses. If they do, the short-sellers’ buying drives prices even higher. Looking further into the topic, academic research is mixed as to whether high short interest indicates that a stock is likely to move up or down.

So, my answer to your e-mails asking why I haven’t given you a screen for finding shorting candidates is itself short: I’ve yet to find one.
published 2/19/06

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