Today we'll keep it simple, and look at the basics of two popular ways of going short.
Short Approach #1: Individual Equities
The first (and perhaps most widely known) way to go short is with individual equities. This is where you pick a specific stock, or perhaps a basket of stocks, to be short. You then "borrow" the shares and sell them in the open market, with the intention of buying them back later at a lower price. The difference between your initial sell price and your later buy price is your profit (or loss, if the shares rise rather than fall).
In some ways, being short individual equities is the most aggressive way to go. The play being made here is concentrated on the fortunes of one company or one industry, as opposed to being spread out over a broader range.
The risk in shorting individual stocks is that the fortunes of the company don't always align with the fortunes of the broader market. If a specific company gets taken over, reports better-than-expected earnings, or sees its stock subjected to a "squeeze," the end result can be painful.
But of course, the rewards that offset that risk are also potentially great. It is only by shorting individual companies that one can find stocks that fall from, say, $60 per share to less than $1, as Fannie Mae (FNM:NYSE) did in 2007 and 2008.
Many hedge fund players make what one might call "investment shorts." The idea here is that a company or an industry is assessed with the same metrics that one would use in determining a normal investment. What are the prospects? How is the cash flow? How is the debt load? Is the business model sustainable? Is the franchise strong? And so on.
The difference is, while normal investors look for companies with bright futures and a good chance of being rewarded with long-term capital appreciation, the "investment short" concept seeks out the opposite. A good candidate for being shorted over a long period looks like the opposite of a value stock -- most likely overvalued and overleveraged (too much debt on the books)... quite possibly overhyped (too much "blue sky" built into the price)... and, if at all possible, a franchise in ill health that looks subject to the ravages of competition.
Fraud and obsolescence are two key concepts that drive "investment shorts." Hedge fund managers will often short a stock with an eye for long-term decline if they believe the numbers are phony. The most notable case of this was short-seller Jim Chanos and his bearish bets on Enron, back when the company was still a high flyer. Nobody but Chanos saw the fraud at first, and Chanos made a killing as Enron imploded.
Obsolescence is about the loss of competitive advantage as a company's products go out of style or its technological edge is lost. A powerful example of this is Eastman Kodak. Kodak, the long-time leader in camera film, saw its franchise essentially gutted by the rise of digital cameras. Paul Simon once song, "Momma don't take my Kodachrome away." Momma didn't take it, but the marketplace did, replacing it with something better.
Short Approach #2: Exchange-Traded Funds (ETFs)
The second most popular way to go short is through the use of ETFs, or exchange-traded funds.
ETFs have been around for a long time, but their rise to market dominance has been a relatively recent phenomenon. Many observers think ETFs are only going to grow in popularity, eventually posing a big challenge to mutual funds in terms of attracting investor dollars.
A big advantage of shorting an ETF is the lowered risk of being blindsided by individual company news. With an ETF, your position is not subjected to the highs or lows of individual news items. Instead, your fortunes rise or fall on the "basket" of equities represented by the ETF.
Let's say, for example, that you had a low opinion of solar stocks (just to give a hypothetical example). For whatever reason, your analysis tells you that the solar space on the whole is likely to do poorly over the next few quarters.
With this conviction in hand, you could find a few individual solar stock names to go short. Or you could simply short TAN, the Claymore Global Solar Energy ETF, and get exposure to a basket of solar names in one fell swoop. ("TAN" as in sun tan, get it? A lot of ETFs go the cute route -- there is an agribusiness ETF, for example, with the symbol MOO.) Anyhow, using an ETF like TAN lowers your transaction costs and improves the odds that the trade will reflect the fortunes of the solar industry on the whole, rather than the peculiars of any one stock.
Watch Out for Weightings
Probably the biggest thing to watch out for with ETFs is the risk of poor construction. Before going long or short an ETF, it's always a good idea to look at the "top 10 holdings" to see how that particular ETF is built. (You can find out the top 10 holdings right through a simple left-hand link on the Yahoo Finance page.)
As an example of holding discrepancies, consider the two most popular "consumer retail" ETFs -- RTH and XRT.
If you look at the top 10 holdings for RTH (
which you can get from this link), you'll notice that RTH is weighted roughly 20% toward Wal-Mart, 12% toward Home Depot, and 10% toward Amazon.com. That's pretty lopsided. In a way, RTH is a big bet on just three companies -- Wal-Mart being the biggest component of them all by a large margin.
Now consider the top 10 holdings of XRT, another big consumer retail ETF. (
You can see those holdings here). It's easy to see that XRT is put together very differently -- and much more logically. There is no single company in the XRT "basket" that accounts for more than 2% of the total.
The above comparison shows why I much prefer XRT over RTH as a trading vehicle. It's more of a true representation of the general retail space, as opposed to being tilted toward three big companies. If I wanted to make a specific play on Wal-Mart or Amazon, I would just go with Wal-Mart or Amazon.
It's interesting to dig through the holdings for various ETFs to see what you get. For example XLE, the popular energy ETF, has more than 31% of its weighting toward just two names -- Exxon and Chevron.
International ETFs in particular -- the iShares for various countries -- are where you really need to pay attention to the weightings. For instance, the
iShares Spain ETF (EWP:NYSE) has more than 40% of holdings in just two big players, Banco Santander and Telefonica SA. That's hardly representative of the entire country as the name suggests.
As usual, we've only scratched the surface here. The next time we visit this topic, we'll talk about two other popular means of shorting -- options and inverse ETFs.
How to Boost Your Portfolio No Matter What the Markets Are Doing
No matter what the news is in the markets... how long this global recession lasts... or how well your investments are doing -- you could boost your portfolio's bottom line with the
potential for triple-digit gains. Learn how in our report,
5 Hot Stocks for 2010. It's yours FREE... all you have to do is
tell us you want to receive a copy.
And as a bonus, we'll also make sure that you're receiving
Taipan Daily, the free e-letter I write for... the investment e-letter that's easily the most profitable five minutes of your day.
Join Us Today... It's All Free!
Justice Litle is Editorial Director for Taipan Publishing Group and Taipan Daily – a free investing and trading e-letter – as well as the editor of Justice Litle’s Macro Trader.
If his name sounds familiar, it’s because Justice is regarded as one of the top trading experts in the world. While pursuing a Ph.D. at Oxford University in England, Justice began his financial adventure that includes researching and investing in trading and commodities.
Because of his trading expertise, Justice has been quoted in The Wall Street Journal... written multiple articles for Futures magazine... given regular market commentary to the likes of Reuters and Dow Jones, and contributed to the book Trend Following. In fact, under his guidance, Outstanding Investments, a world-class natural resource newsletter, delivered a top-rated performance two years in a row.
You can read more from Justice in Taipan Daily. Simply sign up, and you’ll start receiving Taipan Daily… plus you’ll receive the Free Special Report, 5 Hot Stocks for 2010. Register Now!
