Now It's Time for Short-Sellers to Panic

Now It's Time for Short-Sellers to Panic
By Dan Caplinger

May 5, 2009 Comments (0)


For more than a year, investors who own stocks have heard over and over again that they shouldn't panic. Now, their patience has finally earned a reward, and it's time for another group of market participants to have their turn at dealing with a challenging market.

Short-sellers have turned bets against the market into huge profits ever since the market peaked in late 2007. With so many stocks losing huge portions of their value, finding a profitable short-selling candidate has been like shooting fish in a barrel.

But over the past two months, the market's extraordinary rebound has put short-sellers in the squeeze of a lifetime. As you can see, some of short-sellers' most popular targets have performed extremely well since the market's lows in early March:

Stock
% of Shares Sold Short
Return Since March 9
1-Year Return

Barnes & Noble (NYSE: BKS)
34%
67.7%
(11.4%)
MGM Mirage (NYSE: MGM)
30.9%
305.2%
(80.6%)
Goodrich Petroleum (NYSE: GDP)
24.5%
75.8%
(22%)
Citigroup (NYSE: C)
23.8%
204.8%
(87.2%)
Hovnanian (NYSE: HOV)
23.5%
400%
(74.7%)
Green Mountain Coffee Roasters (Nasdaq: GMCR)
44.4%
97.1%
96.7%
Bankrate (Nasdaq: RATE)
36.1%
47.2%
(46.5%)
Sources: Yahoo! Finance and WSJ.com. Short interest as of April 15.

Those rebounds have been extremely painful for anyone who sold those stocks short. No matter how bad things get, investors who buy stocks can never lose more than what they paid for their shares. But as these examples show, short-sellers can do much worse. If you sold Hovnanian short in early March, for instance, you've now lost four times as much money as you initially received when you sold your borrowed shares.

Why do they do it? In some ways, short-sellers have much in common with any other investor. They do their research and try to find promising candidates for their investing strategy. It's just that the "promising" stocks that shorts look for are those that are least likely to do well -- companies whose businesses are failing or whose prospects have gotten so pumped up that there's no way the reality can ever meet shareholders' expectations.
Under ordinary market conditions, you'll usually find a few companies that fit the bill. In the past, stocks like Krispy Kreme and Crocs acted almost perfectly for short-sellers; hopeful investors bid up shares to the stratosphere, and then all it took was having the patience and financial resources to wait for the company's fundamentals to fall apart.

An embarrassment of riches

Now, though, short-sellers are in the same position that most investors enjoy at the top of a bull market. Shorts have had many chances to make huge amounts of money in the past year, but now, many of their best candidates have already fallen substantially. With many stocks having fallen 80% or more, the risk for short-sellers who continue to bet against the market has risen exponentially.

Perhaps the most dangerous part of short-selling is that if you keep upping your bet on a particular stock, you can end up being right about the stock dropping but still lose money. For instance, say you shorted 100 shares of General Motors last year at $22 per share. If you closed out the short now, you would realize a little over $2,000 in profit.

But now say you upped your short position to 1,000 shares. If GM stock rose to just $4 -- still an 80% loss from last year's levels -- you would have lost all your profits and then some.

Yet that's the dilemma short-sellers face now. Do you increase your exposure on existing positions, hoping shares will fall back but taking on a lot more risk -- or do you give up and cover your shorts in the face of the current rally?

Be panic-proof

There's no one-size-fits-all answer to that question. But by the time the situation comes up, you should already know what you're going to do. If you're going to sell stocks short successfully, you need several things:

An exit strategy.

Even more than with owning shares, you can't afford to panic when the market moves against you. Know your risk tolerance, and know in advance when you'll get out to limit your losses.

Discipline.

It's tough to watch a company's stock rise when you know its business stinks. Irrational markets can last a long time, though, so being patient is essential.

Hedges.

Sometimes, a safer way to short is to buy shares of another stock in the same industry. That way, you can make money overall even if your short does badly, as long as the stock you own does (relatively) better.

Short-selling is not for the meek, so don't do it if you're not comfortable with the consequences. And right now, with the market already having declined so much, short-sellers could find themselves even worse off than investors who've owned shares throughout the bear market.

Fool contributor Dan Caplinger hasn't sold anything short for a long while, though he does have a bunch of thumbs-down positions in CAPS. He doesn't own shares of the companies mentioned.

http://www.fool.com/investing/high-growth/2009/05/05/now-its-time-for-short-sellers-to-panic.aspx