Most investors by nature will "go long" when they buy stocks. Few investors naturally will short stocks (or bet
on their decline) because they really don't know what to look for. Some investors see the shorting process as
somewhat counter-intuitive 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.
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 period of time. 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 their investment is
As you can see from the chart below, the declining trend will make it difficult for an investor to gain on a
move higher because the position will need to fight against the major underlying trend, which in this case is
Other technical indicators can also be used to predict a downtrend such as a moving average. Many traders will
watch for the price of an asset 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 a press release. Following this, Wall Street analysts work to compose a report,
and then distribute that report 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 that are trading in the lower end of their 52-week trading
range will trade even lower. Why is this? It 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.
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 exec's have extraordinary
insight into their companies. Use this information to your advantage and time your short sales accordingly.
You don't need to find a company that is on the verge of bankruptcy to successfully short its stock. On the
contrary, 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.
Swelling Inventories/Accounts Receivables
This fits in under the topic of deteriorating fundamentals, but it stands to be emphasized because these are two
of the most obvious (increasing inventories, and accounts receivable) signs that a company is going downhill.
What do these figures tell you?
Increasing inventory figures might not be bad 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 sizeable
inventory jump for no reason, it is a sign that it has goods on its books that are stale, and might not be
saleable. These, in turn, will need to be written off, and will have an adverse impact on earnings down the
Increasing receivables is a bad sign because it indicates that 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 also have to be written off as well at some point in the future.
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 that 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 will be able to confirm whether the company is witnessing the same problems (or opportunities) as
other players in the same industry or sector.
Investors need to be aware that not only does short selling present an opportunity to generate tangible gains,
but also that there are signals to alert an investor about when a stock is about to take a fall. This knowledge
will make you an immeasurably better investor.
Note: In this article I have integrated the
exact content of the original source, to be certain that this information is retained. If you would like to read
this article on the website of the original publisher I recommend you to click the source link below.
Jeroen Snoeks is the founder of UndervaluedEquity.com, a website for
investors passionate about investing in undervalued stocks. ThroughUndervaluedEquity.com, he shares his
experience and knowledge and will soon reveal his personal stock portfolio.