How to Make Money in Stocks: A Winning System in Good Times and Bad, Fourth Edition: A Winning System in Good Times and Bad, Fourth Edition by William O'Neil

Author:William O'Neil [O'Neil, William]
Language: eng
Format: azw3
Publisher: McGraw-Hill Education
Published: 2009-04-12T00:00:00+00:00

Should You Sell Short?

I did some research and wrote a booklet on short selling in 1976. It’s now out of print, but not much has changed on the subject since then. In 2005, the booklet was the basis for a book titled How to Make Money Selling Short. The book was written with Gil Morales, who rewrote, revised, and updated my earlier work. Short selling is still a topic few investors understand and an endeavor at which even fewer succeed, so consider carefully whether it’s right for you. More active and seasoned investors might consider limited short selling. But I would want to keep the limit to 10% or 15% of available money, and most people probably shouldn’t do even that much. Furthermore, short selling is far more complicated than simply buying stocks, and most short sellers are run in and lose money.

What is short selling? Think of it as reversing the normal buy and sell process. In short selling, you sell a stock (instead of buying it)—even though you don’t own it and therefore must borrow it from your broker—in the hope that it will go down in price instead of up. If the stock falls in price as you expect, you can “cover your short position” by buying the stock in the open market at a lower price and pocket the difference as your profit. You would sell short if you think the market is going to drop substantially or a certain stock is ready to cave in. You sell the stock first, hoping to buy it back later at a lower price.

Sounds easy, right? Wrong. Short selling rarely works out well. Usually the stock that you sell short, expecting a colossal price decrease, will do the unexpected and begin to creep up in price. When it goes up, you lose money.

Effective short selling is usually done at the beginning of a new general market decline. This means you have to short based on the behavior of the daily market averages. This, in turn, requires the ability to (1) interpret the daily Dow, S&P 500, or Nasdaq indexes, as discussed in Chapter 9, and (2) select stocks that have had tremendous run-ups and have definitely topped out months earlier. In other words, your timing has to be flawless. You may be right, but if you’re too early, you can be forced to cover at a loss.

In selling short, you also have to minimize your risk by cutting your losses at 8%. Otherwise, the sky’s the limit, as your stock could have an unlimited price increase.

My first rule in short selling: don’t sell short during a bull market. Why fight the overall tide? But sooner or later you may disregard the advice in this book, try it for yourself, and find out the same hard way—just as you learn that “wet paint” signs usually mean what they say. In general, you should save the short selling for bear markets. Your odds will be a little better.

The second rule is: never sell short a stock with a small number of shares outstanding.

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