How to execute a winning shorting strategy

Within bear markets like the one we're in now, short selling – the process of selling borrowed shares of a stock in the hope of buying it back later at a lower price and pocketing the difference – can be an effective way to make money.

But before you start shorting, you need to know exactly what you're doing and how to adequately manage the underlying risk.

What you need before you start shorting any stock is some rationale to the expectation that a company's share price will fall. Rather than relying on dumb luck or a hunch, getting a list of short positions can provide some useful insights (see below).

This is where riding on the coat-tails of professional or institutional investors – traditionally the biggest short sellers – can pay dividends. For starters, having sufficiently analysed key stocks, you're better positioned to make an informed bet on the direction in which the share price might be heading.

One of the first things to note when looking at stocks mostly commonly shorted is that they're not all value-traps or share market basket-cases. Included within the top twenty most shorted positions on the Australian Stock Exchange (ASX) just prior to Christmas, included both the 'Alpha and the Omega' of stocks in the quality-stakes.

These ranged from stocks with some deep-seated issues like Dick Smith Holdings Ltd (ASX: DSH), Slater & Gordon Limited, Metcash Limited (ASX: MTS), Myer Holdings Ltd (ASX: MYR), Woolworths (ASX: WOW), and Cabcharge (ASX: CAB) which is under siege by new market entrant Uber.

Then there are some of the best investment-grade stocks listed on the ASX like JB Hi-Fi (ASX: JBH), Monadelphous Group (ASX: MND), and Flight Centre (ASX: FLT) which have had a whopping 12.76%, 16.91% and 14.04% of their issued capital reported as short (see table).

With investment grade stocks finding their way onto the 'top most shorted' list, you can't assume that a short position in a company is an absolute proxy on its future business performance. However, it can allude to some future value-traps to steer clear of and Dick Smith – now in receivership – is the classic example.

Key guidelines

With that in mind, Rivkin searched for some key guidelines for a successful shorting strategy. Equally important, updates on shorted stocks aren't hard to find, with Daily Gross Short Sales reported by the ASX Limited (ASX) & Chi-X Australia (CHI-X), see http://www.asx.com.au/data/shortsell.txt.

Before you short a stock, keep the potential pitfalls in mind and have rules for both when to get into and when to get out of the trade. Here are some basic principles to follow.

  • Stick to bear or down markets: The vast majority of stocks move in the same direction as the general market, so it makes sense to restrict your short selling to bear markets or clear downtrends. Levels of short selling can provide meaningful clues on what direction those most likely to be in 'the-know' – like large investors and fund managers – think the share market is heading. Short-selling figures by ASIC suggest that the value of outstanding short positions reached a historical high in January. With an extra $2.4 billion added to the value of outstanding shorting positions over January – pushing the total to over $30 billion – this reporting season is shaping up to be unusually bearish. Included among stocks with the greatest increase in short-selling over January were the big-four banks – due to concerns over their loans exposure to resources – and healthcare stocks like Primary Health Care (ASX: PRY), Sonic Healthcare (ASX:SHL), Ramsay Health Care (ASX: RHC), and Virtus Health (ASX: VRT).
  • Concentrate on previous market movers: Early within a stock's up-cycle is typically not a good time to be shorting, unless there's an unforeseen market correction, and this is where it's useful to combine stock fundamentals with technicals – aka charting. Similarly, if a stock's run-up is starting to suggest its running out of steam, look for signs that the share price could come under short-term momentum pressure. Blackmores Group (ASX: BLK) is a classic example; while the fundamentals haven't changed, Blackmores share price lost ground early in 2016 after hitting over $220 a share, and the valuation proposition become less compelling.
  • Only short highly liquid stocks: Ideally, when it comes to shorting, you want to focus on stocks with much higher, institutional-quality liquidity to reduce more volatile swings, up or down.
  • Look for signs of a definitive break in the stock: When shorting, look for a sharp breakdown or clear change in trend. As a general rule, short sellers tend to take note of what head-and-shoulders pattern are telling them. Chartists will no doubt have both Blackmores Ltd (ASX: BLK), and more especially Suncorp Group (ASX: SUN) on radar for any signal of a clear change in trend.
  • Strategically plan profit-taking: Just as you shouldn't buy a stock without having a selling strategy, also make sure you have a plan for when to cover a short sale trade.

You can apply the same basic guideline used on the long side.

Don't let your emotions get the better of you when a short trade is working well. Have a plan for locking in your profits and follow it.

Ten top shorted stocks ASX

Company

Code

% of shorts

METCASH LIMITED ORDINARY

MTS 

20.60

MYER HOLDINGS 

MYR 

19.76

MONADELPHOUS 

MND 

16.91

WESTERN AREAS 

WSA 

15.74

MINERAL RESOURCES

MIN 

14.18

FLIGHT CENTRE 

FLT 

14.04

ALUMINA 

AWC 

13.70

ORICA 

ORI 

13.68

GREENCROSS 

GXL 

12.82

JB HI-FI 

JBH 

12.76

  Source: ASIC 8/02/16