• Log in
• Register free
• Subscribe
• Help
• Tour & Trial IC Advantage

Picking targets to sell short

Created:

30 June 2009

Written by:

Dominic Picarda

Short selling is a vital part of any serious trader's armoury. But the ability to make money from speculating that asset prices will go down can be just as important to long-term investors. This is especially true when the stock market remains in a sideways range for many years, as it did in the 1970s and could do again now. In such an environment, it pays to be able to ride both the upswings and the downswings.

The most popular way to identify which shares to sell short is by technical analysis. Selling something that is already clearly going down can be the best indicator that it might continue to fall. By contrast, if you short-sell a share when it is still rising, you can quickly incur heavy losses. This is particularly painful if you are using leverage - ie, borrowed money - to trade.

As well as looking at shares that are already going down - or at least ones that are not going up - another way of selecting targets is to look at fundamental factors. Short-selling overvalued shares can be a profitable approach, particularly if combined with technical analysis. Ideally, we would seek out shares that are both fundamentally expensive and technically overbought or already falling.

In order to identify shares that look vulnerable both on the charts and in their accounts, you need a package that includes both. I'm a heavy user of ShareScope software, which can be equally used as a charting tool or as a source of fundamental reports. I must admit that I mainly use it for the former, but I have met quite a few investors who use it the other way around.

To test out a shorting strategy using both fundamental and technical data, I ran couple of searches on my ShareScope Pro system. I instructed it to scour the FTSE 350 index for shares that met certain criteria that I reckon makes them ripe for shorting.

As a measure of poor value, I looked for companies that trade on high multiples of their sales. I also sought out shares that enjoy strong levels of broker approval - the logic being that when the City loves a share, it often ends up disappointing.

In addition to dearness and hype, I instructed ShareScope to scan for shares whose financial position had deteriorated in various ways. These included return on capital, and the relationship between cash flow and profitability. As for technical analysis, I looked for shares whose medium-term momentum - as measured by the weekly relative strength index - had deteriorated.

Who's riding for a fall?

My search threw up some interesting names, but the one that grabbed my attention most was oil giant BP. The price of the FTSE oil & gas sector - of which BP is obviously a major constituent - is high compared with the wider stock market. This raises the possibility of opening a long position in the wider market while simultaneously short-selling BP, thereby capturing the relative gains.

Having identified short-selling targets, we then need to decide how to actually sell them short. The most logical instruments are spread bets and contracts for difference (CFDs), which enable investors to short-sell easily. By placing a sell order on an asset that we don't already have a position in, we are instantly short of that asset. To take our profits or cut our losses later on, we merely reverse our steps and place a buy order, thereby closing the trade.

Although spread betting and CFDs are most commonly used for positions lasting a few hours or days, they can also be employed for longer-term strategies over a few weeks or even months. To maintain such a position, it is usually best to use the 'futures-style' bets that run for up to three months at a time. Keeping the bet open simply involves rolling it over periodically.

An alternative way to gain from a falling share price can be to take a fixed-odds financial bet. Such bets can last for six months, although the range of shares that they cover is limited. They also require us to reach a precise forecast of where a price is going to reach. So, you can open a trade that promises to pay out a specific sum if BP's price falls to a certain price within six months.

Read more about spread bets and CFDs at www.investorschronicle.co.uk/investmentguides.

You can replicate some elements of this screen using the IC's stock screening tool: www.investorschronicle.co.uk/data/stock_screener.cgi

• Share Tips
• Trading
• Companies
• Markets and Sectors
• Columnists
• Stock Screens
• Funds Data
• Research Tools
• Investment guides
  • Shares
  • Retirement
  • Short-term trading
  • Funds
  • Alt. Investments
  • Tax
  • Attend IC events
  • Understand jargon
• Events
• Q and A

requires IC Advantage

---

Win £1000

You could win a grand by voting in the IC/FT Wealth Management Awards

Click here to vote