Shorting Stock Bubbles
Going short, betting that a stock will go down, is something that only experienced investors should do. When you short a stock, you sell shares of the stock without actually owning them (your brokerage borrows the shares for you which enables you to sell them later). You later must purchase back the shares, which is known as covering. When you short a stock, you hope to sell high and then later buy back low.
The downsides of going short are obvious. In general, the stock market goes up. If you think a particular stock goes down, and you are wrong, you are liable to lose an unlimited amount of money if that stock keeps on going up forever. Of course, practically speaking, if you short $5,000 of a stock, it is unlikely that the stock will increase 100X anytime soon, but the dangers are pretty clear.
A major reason investors to choose short a stock if they think that company has become grossly overvalued. For example, during tech boom, many tech companies that had few revenues and negative earnings were valued in the billions. Investors kept buying these stocks on the hope that they would somehow, magically have future profitability. Those that shorted these stocks often made a fortune.
Shorting a stock and betting that it is a bubble is a nice way to make some money. It also lowers your overall exposure to the stock market (assuming you have a significant amount of money in stocks). Stock bubbles can be broad-based, such as the late 90’s tech bubble, or individual stocks. For example, Crocs (CROX) zoomed up from its IPO price in the teens up to $80 a share and then quickly cratered back to its IPO price. Those that bet that its shoes were nothing more than a one-trick-pony fad were right. Here are some tips if you hope to short bubbles:
1. The news and commentary about the stock should be almost universally optimistic. There should be a lot of talk of pie-in-the-sky growth, without clear indications how the company will ever be able to realistically achieve that growth.
2. It is very important that you understand the company and its sector in question. The way you have an edge in the market, in general, is by understanding a company better than the market does. If you are going to bet against a stock, you better be able to justify to yourself why you are making that bet.
3. Just because a stock has a high PE does not mean it is overvalued. Its last year’s earnings may have been artificially depressed or there may be extremely good reason to believe that its earnings will significantly expand soon.
4. Often, the dumb, hot money will chase bubbles. You know the type of guy that always bets on the hot sports team or was sure that Amazon and Yahoo could only go higher in 1999? If you see the type of dumb money chasing a certain stock or sector, it may be time to short them.
