Roundtable: How Fools Use Short Strategies

As part of our special series on short selling, we asked several Fools to tell us what sorts of strategies they use to bet against stocks or financial markets. Here are some of the things you'll find them doing when they think an investment is headed down.

Anders Bylund, Fool contributor: The idea of making money from a negative market prediction is just as valid as betting on the next bull market. I've made money and lost money both ways, but I'm out of the short-selling game these days.

Why? Because I simply can't justify taking the risk anymore. There's an unlimited downside but a very limited upside to shorting a stock, while straight-up share buying works the other way around. Buy a stock, and the worst you can do is lose the original investment. Make an incorrect shorting bet, and the pit is bottomless. Also, you rely on brokers and market makers shuffling around borrowed shares in hopes that you won't be left with a naked short position. The grinding gears of the immense machine are too complex for my blood.

If I really see a company falling to its death, I can use options to take much safer positions. The volatility in stocks like Apple (Nasdaq: AAPL  ) and Netflix (Nasdaq: NFLX  ) makes them good candidates for certain types of short options strategies, where higher volatility means that you get paid more for opening a position.

Or I can simply rate the stock "underperform" in CAPS to keep track of my own predictions. That's exhilarating enough for this Fool. Maybe it should be enough for you, too.

John Del Vecchio, Fool contributor: I've been shorting stocks exclusively for more than 10 years, and my process has remained fairly consistent during that time, with a few refinements. The genesis of my strategy comes from my time working with Dr. Howard Schilit, the well-known forensic accountant, at what is now RiskMetrics Group. While there, I quickly learned to focus on companies where management was accelerating revenue recognition. As long as end demand for a company's product is strong, then everything will take care of itself.

But when management teams start pulling financial levers to paste over deterioration in their underlying businesses, trouble often looms. For instance, in the casino services industry, both WMS Industries (NYSE: WMS  ) and Bally Technologies (NYSE: BYI  ) are offering extended payment terms to customers right now, which pulls future revenue into the current period and creates a revenue "gap" that must be filled. I'm very wary of those stocks right now.

There's no incentive on management's part to engage in these gimmicks when business is strong. Revenue is the lifeblood of any company. It drives earnings, cash flow, and often the strength of the balance sheet. So when management is playing games with revenue, my concern level is higher than at any other time.

Chuck Saletta, Fool contributor and Inside Value team member: Personally, the only short strategy I've ever employed has been selling covered call options on stocks that I've owned. While not a "naked" short, it's still a sale of a security I didn't directly own. I've found the strategy to be great on three fronts:

  • Enforcing selling discipline.
  • Capturing a bit of income on something I was willing to sell anyway.
  • Profiting from the time decay when the options were priced for extreme volatility.

There are often chances to earn 2% or so in a month by selling someone the right to buy my shares from me for 3% or so above the current market price. On one hand, if the shares skyrocket, I'd lose out on the gain above my locked-in approximately 5% total return. On the other hand, if they rise slightly, go nowhere, or fall, I'd still be 2% better off than I would have been by simply holding. It's pennies on the dollar, to be sure, but repeat it often enough, and those pennies certainly do add up.

Sometimes, the results can even be better. For instance, back in September, I sold calls on my shares of Discover Financial (NYSE: DFS  ) , a Motley Fool Inside Value selection. I got $0.55 per share for the obligation to surrender those shares at $15 by mid October, at a time when the stock only sold for around $13.50. In essence, I got a 4% option premium and retained the right to accept as much as an additional 11% gain, were it to close above $15 by expiration.

I ended up closing out the short by buying back the calls at a profit to me, as the time-decay deterioration worked in my favor. But had the shares taken off, I still would have locked in about a 15% return in just over a month, which is nothing to sneeze at.

What sorts of strategies do you use to bet against the market? Share your experience in the comment section below.

Fool contributor Dan Caplinger compiled this roundtable article. He doesn't own shares of the companies mentioned. Discover Financial is a Motley Fool Inside Value pick. Apple and Netflix are Motley Fool Stock Advisor selections. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy won't leave you short.


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