Successfully Shorting Stocks

In this feature we cover Evil Knievil’s – perhaps the UK’s most prominent bear raider – piece on what to look for when shorting stocks, and the pitfalls that you should look to avoid when trading short.

1. Have the courage of your convictions and be comfortable in the minority.

Control your emotions.  One can be caught out by an out of the blue bid.  Thankfully, this is a rare occurrence, but nevertheless there is an amazing amount of hubris and stupidity displayed by company directors, and the lure of a bargain can tempt a move on an ailing business. In this instance, depending on your spreadbetting firm and their offers of ‘Guaranteed Stops’, it pays to use a guaranteed stop to lock profits on the way down and protect yourself from the possibility of a 30-40% gap up. The ‘guarantee’ is generally set at a minimum of 10% from the current share price and is typically only offered on the top 350 stocks.

If you are on the right side of a short position, the short tack should hopefully be a relatively lonely existence. The more there are loud voices on the bulletin boards and in the press proclaiming what a cracking buying opportunity this stock is, the better. Experienced traders have time and again witnessed what happens in the early stages of a bear market; the media and investors in general, so conditioned by the recent rise in prices, believe that the first pull back is yet another buying opportunity. This buying into the decline generally continues.

That this buying is contrary to experience is evidenced by the fact that the 1,3 & 12 months’ biggest risers’ and fallers’ lists, which you can find in publications like the FT, disclose that the biggest fallers generally display a continuing theme in that they persistently feature in all three lists. This bears out the adage that ‘the trend is your friend’.

2. Be aware of borrowing restrictions, particularly when a company is in its death throes

This is an important technical point that can catch out the novice shorter. To understand the development of the problem, it is important to appreciate what happens when you short a stock.

Your spreadbet firm will sell the actual stock in the market. On the other side of this, there will be a buyer, who will need delivery of stock. Therefore the spreadbet firm has to borrow stock from an institutional lender.

Incidentally, the institutions which lend out their stock receive a borrowing fee in exchange for this that than can vary from less than 1% per annum to double digits, depending on how much the stock is in demand to be borrowed.

The institution that has lent out the stock may, at some point, wish to actually ‘call the stock back in’. This means that your spreadbet firm, in the absence of being able to find a new borrowing avenue, will very likely require you to close your short, i.e. buy back the shares in the market so that these can be delivered back to the lender. If there are no ready sellers of stock for whatever reason, there can be a mad scramble for stock. What can now occur is the dreaded ‘short squeeze’.

In the UK it is quite difficult to get accurate ‘stock on loan’ data. Therefore you are more at risk of a sudden call from your spreadbet firm asking you to cover your position than might be the case in overseas markets. In the US there are a number of websites that show stock on loan data such as the Nasdaq.com site.

Another lesson here is that, if you have made 80-90% of the potential fall, do not be a stubborn theorist.  Instead, do look to take spoils off the table, i.e. if you have shorted at 100p, say, and the stock is presently priced at 20p, don’t be hero and look to take the last scraps and expose yourself to a short squeeze.

3. Covering your shorts

And so we come to the all important short covering element. Basically, there will be 3 primary buy back reasons. They are:

(i) you are stopped out by way of a price rise that has triggered your own personal money management parameters (hopefully with a stop loss guarantee in place).

(ii) the stock no longer offers an attractive risk/reward profile. A banked profit feels much nicer than a paper profit.

(iii) Finally, in the immortal words of John Maynard Keynes, “when the facts change, I change my mind. What do you do sir?” If the reasoning for the short changes, and leaves the argument to be short in doubt, close the short.  Be warned that most investors are indecisive when confronted with this problem.

Article reproduced from the May edition of Spreadbet eMagazine