5 Rules for Making Big Profits Shorting Stocks

Not only is it possible to make big bucks on falling stocks, but savvy short-side investors do it all of the time. Whether you're shorting stocks the traditional way or doing it the smart way (more on that in just a minute), choosing a name to play to the downside should be just as well thought out as any long-side play that you add to your portfolio.

But how do you go about finding spectacular short-side plays and, more importantly, profiting from them? I have five solid rules that shed some light on how to survive and thrive when shorting stocks.

Next: Rule #1

I do not recommend that individuals ever short a stock the traditional way—borrowing shares, selling them, and then buying them back when they are cheaper to repay the loan. When you short a stock your potential loss is theoretically unlimited. In a long position, the most you can lose is 150% if you borrowed on margin to leverage your investment. But with a short position, if you borrow a stock when it is trading at $10 and the stock runs up to $200, then you are out $190 a share—19 times your original investment!

Instead, when you want to bet on a stock falling, buy a put option. With put options, the most you can lose is the price you pay for the puts. Plus, put options give you more leverage, and a rapidly appreciating put generates a better percentage return than a traditional short position.

Next: Rule #2

A short position should always be based on fundamentals. Study companies' business models, management, product lines and prospects rather than just looking at their charts. There are a lot of technical gurus out there who use past stock performance as prelude to where it "should" trade next. But just because a company seems like it's doing OK doesn't mean that it can keep up its past performance, especially if it's starting to crumble from the inside.

Wall Street seems to want to believe the best in companies, and its pundits often pooh-pooh less-than-stellar stock performance as temporary. My tried-and-true method of making money on the short side is to get situated while everyone else is rooting for a company's recovery.

Next: Rule #3

One put option contract represents 100 shares of the underlying stock, so if you see an option trading at $3, your investment would be $300 for a contract. If that stock heads off a cliff and your put shoots up in value to $6, that's a sweet money-doubler. But if you buy an option at $2 and it goes up to $6, you've effectively tripled your money. And if you're going to go for gains, why not go for the biggest ones possible?

I have avoided some short-side positions because the premiums on the puts were simply too expensive, making the risk/reward ratio unfavorable. The lower the put entry price, the more money you can make when it turns in your favor. And if things don't go your way, then that's less money you put at risk.

Next: Rule #4

How do you go about picking the biggest losers to short? If you wouldn't be caught dead owning the shares, that's a pretty good indicator that it belongs in your short-side portfolio. If a company, stock or sector is ugly on the inside, it's only a matter of time before the ugliness—in the form of broken business models, less-than-spectacular corporate leadership, companies that are no longer true competitors in their fields, and other conditions that signal their crumbling fundamentals—shows on the outside. And then the stock goes down.

However, a word of caution: The underlying stock must not have any predictable, potential upside catalysts on the horizon, such as an influx of private-investment capital. Even if you know the stock is a fundamental disaster, when cash flows into it, the smartest thing a short-side investor can do is to run, not walk, in the other direction.

Next: Rule #5

Even if you think a stock will continue its slide, I urge you to close a big win and then open another position with more leverage (i.e., with a lower strike price and/or later expiration date) utilizing only your original investment dollars so you can put profits in your pocket. This is called "rolling" a position.

Because options come with an expiration date, you may need more time to ride a stock's slide as far as it can go. It may take a year or two for the bad news to fully play out for a stock, but you may only have nine months with your put option position. So, whether you have a winner and need to preserve your profits, or if time's running out and you haven't yet gotten the results you expected, you can always buy more time to let the position play out.

(Michael Shulman)