White Top View series Short Story on Short Selling, Part 4
Investors selling short need more
than knowledge and timing
They must also consider a diverse number of factors.
9 Major short selling factors:
This is Part 4 of the White Top View series Short Story on Short Selling. In Part 1, Novice investor asks, “Explain selling stock short”, we opened our discussion of selling short.
In Part 2, Investor, is a stranger selling your stock? we continued by explaining that short sellers must borrow stock. So they could be selling stock that you own!
Part 3, Investors must know the short story, covered the sophistication of short sellers, why they target larger companies and introduced the 9 factors short sellers must consider.
Experienced short sellers bring a wide field of vision to the market. They carefully examine and consider each influencing factor. Then before taking action they look at the combined effects of all factors.
Only after being convinced that the odds have lined up in their favor will they take action and sell a stock short.
Today in Part 4, we touch on the first two major factors.
Two Major Short Selling factors:
1. Market facts: the market itself and the overall investment climate must play a role in any shorting strategy. In strongly running bull markets, profitable shorts are less common. Shorts generally work best in weak or falling markets.
Eventually every down-trending market reaches the bottom. At market bottoms, when most investors have negative feelings, shorting can be both difficult and dangerous.
When the bottom has been reached the only way is up. So shorting at market bottoms is financial suicide.
In strongly rising bull markets shorting can be very challenging as well. Even when the stock of a company trades at incredibly high prices, betting that it will soon fall can be very risky. Being wrong gets very expensive.
The market can assign insanely high valuations for a very long time. There are numerous examples of companies not making money or with little or no revenue that trade at high stock market values.
Reality does eventually catch up with every stock. However, that can take a very long time. Mis-timing when those values will correct to a rational level has hurt numerous short sellers.
Shorting the stock of such companies can seem very logical. However, the market is not logical, it is the market. Shorting, especially in a strongly running bull market, can be a very costly mistake.
There are examples of short sales working very well in virtually any market. However, the market factor generally keeps short sellers quietest in both deeply depressed and very strong bull market runs.
2. Corporate facts: by far the most important factor for short sellers are the business fundamentals of the target company itself. Getting negative information before it is priced into the market can ensure a good short.
That can be as close to a sure thing as any short seller can get. Without a doubt, even in the most unfavorable market conditions, a very profitable short sale can happen when the fundamentals are negative.
Knowing, surmising or suspecting that a company will soon have to release very bad information can be a very good opportunity to sell short. Get the fundamentals right and even a strong bull market will not protect a company with very bad results.
Good news for the short seller is bad news for the company. That news usually comes in the form of poor operating results, reports of management misbehavior or a negative market outlook.
When the short seller has facts or belief that compel the conclusion that the shares are significantly overvalued, the short selling begins. This is done quietly so buyers are not spooked. After all they need someone to buy the overvalued shares that they have borrowed.
Simply taking the short position does not guarantee the short seller a profit. To profit the short seller must be right as well as get the desired and timely negative market reaction to the bad news. Get the timing wrong and “right” can end up being much poorer if the market does not agree with the short evaluation.
In most cases short sellers expect the market to react negatively as soon as the bad news or revealed information, gets released. Should the anticipated poor information materialize, a significant price drop can happen in minutes, hours or days.
However that does not always happen. Short sellers can tear their hair out in frustration when the anticipated reaction does not happen. At times the market can seem to shrug and carry on. As noted above, the market is not rational. It is simply the market; the result of collective human behavior. That is often not rational or logical.
Our next discussion will continue to cover other factors investors consider before selling short.
Do you think the current market is a good one to sell short? Please comment or ask a question.
These bite sized lessons are intended to demystify investing. You can become a knowledgeable confident investor, one small step at a time. Please ask questions, I can help you better understand markets and investing. The White Top Views email list will not be shared or sold.
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White Top Investor
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Links to all parts of the White Top View series, the Short Story on Short Selling, follow below:
Part 8, Short selling has rules
Part 10, Four more positives of short selling
Part 12, Shorting stocks is hard