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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 |
