Short selling 101 – How to pick a stock to short sell
Each month at Stockhead we write an article on the most shorted stocks on the ASX. But what exactly is short selling and why all the fuss?
In the second of a two part series on we look at how to choose a stock to short sell and why some are more shorted than others.
With more than 30 years experience working in financial markets, including State Street Global Advisors, Goldman Sachs, JB Were, Australian banks and now consulting, Mark Wills has extensive experience. He’s our Short Selling 101 tutor.
Wills said short selling is much the same as picking stocks for the long term; it involves detective work. The dominating player in equity markets is long traders who own the stock in the hope it will rise over the long term.
But short traders, are the opposite and don’t own but rather “borrow” stock they think will fall. A short seller’s plan is to buy the stock back later for a lower price and after repaying the initial loan, making a tidy little profit.
As we learned from our last article, shorting typically is done by investors in the professional market because the activity requires a level of operational skill that individual investors may lack.
Short selling is common among hedge funds when they believe the value of a stock or security is likely to fall.
“Hedge funds are usually but not always driven primarily by fundamental analysis,” Wills said.
“Their major focus usually starts with deep fundamental situational analysis.”
He said short selling usually involves finding an overbought indicator and looking for patterns to find some indication that the stock is ripe for a fall.
Wills said a short seller will use tools, such as different chart patterns or indicators used specifically for predicting the start of a decline.
He said they may use an overbought indicator like a relative strength index (RSI), while they may also look at trend indicators such a short-term moving average (MA), which aims to create a constantly updated average price.
Wills said other indicators short sellers may be looking at include earnings that are lower than consensus, poor outlooks, lawsuits, changes in regulations which could affect a company or adverse news headlines.
He said it’s important then for short sellers to determine if an indicator such as a negative news story will set the company up for a short or long-term decline.
A long-term decline can start with a spike down but is most likely triggered by a series of negative events that give traders confidence that a longer-term downtrend is developing.
Traders react by selling the stock. A series of negative earnings reports is the type of fundamental that often attracts the short seller.
Not surprisingly, it seems the best time to start shorting stocks is during a bear market, which is when overall stocks in a sector or market follow a downward trend.
Wills use an example of Covid-19 being initially identified in Australia as a news event which could trigger buying of stocks both long term and eventually short term.
“Imagine as a hedge manager you read about the man from China in late January 2020 who was had tested positive for Covid-19 in Australia,” he said.
“You would start to think ‘what stocks could benefit from this event?'”
Wills said Sonic Healthcare (ASX:SHL) may spring to mind. With their massive pathology network the company could earn huge profits due to the expansion in the need for viral testing.
He said you may also identify Ansell (ASX:ANN) as they produce PPE gear. Globally their sales will also likely grow. Lastly you might think of CSL (ASX:CSL) and their growth potential from the viral vaccine division.
“You buy all three stocks at the end of January 2020 and monitor the global death and infection rates,” he said.
“You see that at the end of June 2021 the NSW government starts to ease restrictions and looking at other pieces of information you think that the rate of bad news will slow, and so want to get ahead of the market.”
Now Wills has put some prices around our stock picks. You bought CSL at $312, ANN at $32.04 and SHL at $31.67. At the end of June 2021, the share prices are CSL at $285, ANN at $42.14 and SHL at $36.70.
“So you lost about $27 on CSL (8%) but made about $10 on ANN (30%) and $5 on SHL (16%) and since you evenly allocated to each stock you have made a good profit,” Wills said.
However, you think that the prices will fall because the stocks have done so well in an abnormal period.
“So you sell out all your stock realising a profit and so then you want to go short the stock price,” Wills said.
He said you look in the options markets thinking you might buy some put options but the impounded volatility has made their prices high and unattractive.
Call options are also expensive, so you decide to sell some at the money call options with three months to expiry.
“But you also think that the decline in the share prices could run for longer than three months so to profit from that you short stock,” he said.
So, besides selling all your physical shares you then sell the same amount… but you do it via a short sale and your positions look like:
ANN at -$42.14, CSL at -$285.00, SHL at -$36.70 (note the negative means a short position).
So to close out positions to buy back the stock, this time making a profit on all three stocks, the new prices look like:
ANN at $21.83, CSL at $269.00, SHL $32.94
“Notice how the thinking driving all the trading was based around an interpretation of stocks affected by Covid-19,” Wills said.
“The decision to buy shares was driven by a desire to profit from excessive demand for the underlying companies’ goods and services.
“When you thought this demand would drop then going short was a logical extension of going long.”