5 Short-Side Investment Rules

(by Michael Shulman)

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 a stock the traditional way or doing it the smart way -- which is to buy put options -- 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 on the "dark side."

First rule -- If we don't stand a chance of winning, then we don't play

The underlying stock must not have any predictable, potential upside catalysts on the horizon.

In 2008, we learned this with Palm (PALM), which our ChangeWave Alliance surveys showed was getting beaten with the ugly stick by smartphone manufacturer extraordinaire Research In Motion (RIMM), whose BlackBerry was living up to its "CrackBerry" moniker at that time.

Things were going our way, playing the short side of PALM, until a very surprising influx of private-investment capital arrived to save the day. Even though nobody in their right mind should have been buying PALM (the company or the stock), it's amazing how much impact a significant cash infusion can make on potential shareholders.

So, when our Alliance research showed that Sears' (SHLD) perception was sliding among customers, but with financier Eddie Lampert on the horizon -- the man who runs the hedge fund that owns Sears -- there was no way we were going to short a company with arguably $140 billion in real estate value on the balance sheet with Lampert at the helm.

Bottom line, a stock may be a fundamental disaster, but when cash flows into it, the smartest thing a short-side investor can do is to run, not walk, in the other direction.

Second rule -- A short position is always based on fundamentals as though it were a long-term position on the long side

I am a stock-picker at heart. That is, I study companies' business models, management, product lines and prospects instead of looking at just 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. And my tried-and-true method of making money on the short side is to get situated on the short side while everyone else is rooting for a company's recovery.

We're not day-traders, looking for a quick 3% to 5% gain and heading for the hills whether or not we get it. Instead, we are doing comprehensive analysis and putting our money on the bets that stand the greatest chances of paying off … and paying off big.

Don't get sucked into "trade-only" plays. Even if a chart looks lousy and a trade looks good, you should never go against fundamentals. Sure, you may miss something here or there, but the discipline you exercise with your long-side investments is also vital on the short side.

You may be tempted to head for the hills at the first sign of good news for a shorted stock, but just like when there's bad news for a good stock, you must repeat to yourself that "This, too, shall pass" when you see a bad stock caught in a temporary updraft.

Sticking to fundamentals gives us confidence in the logic of a position and enables us to wait out market volatility.

Third rule -- Look for reasonably priced puts

Just like stocks, options come in all shapes, sizes and prices. But if you're going to be trading options, as we do on the short side, why not take advantage of the inexpensive but tremendous leverage that they offer?

Remember that one put option contract represents 100 shares of the underlying stock and that option prices are quoted per share. 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 there.

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 --and therefore the risk/reward ratio was unfavorable. The lower the put entry price, the more money you can make when it turns in your favor. Accordingly, if things don't go our way, then that's less money we put at risk.

If a $4 put only goes to $5, it's a gain, of course. But if you're only in the market for 25% gains, you may be better off sticking with stocks.

Fourth rule -- Look for a perfect storm

There are many reasons to short a stock. If you wouldn't be caught dead owning the shares, that's a pretty good indicator that it belongs in your short-side portfolio. But how do you go about picking the biggest losers?

Like the saying goes, "It's what's inside that counts." And 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.

Martha Stewart Omnimedia (MSO) is a great example of a two-pronged recession play -- as it has been impacted by both the housing depression and the pullback in consumer spending.

Given that the consumer drives up to 70% of the economy, and also given that our Alliance data told us that consumers across various income brackets were going to be toning down their spending going into 2008, we saw Omnimedia as a perfect target, as it was barely profitable when consumer spending was on track.

Even better for us, it is also a poorly managed company, which meant that even if the company recognized its flaws, it couldn't execute a turnaround in its business model within a reasonable time frame -- if at all.

Throw in some lackluster holiday sales and a bleak outlook (because, if it doesn't make its money around the holidays, then when will it?), and your feeling of pity for this company is the only thing that will keep you from enjoying outsized profits!

fifth rule -- Close and/or roll winning positions

Even if a stock continues to slide, I urge you to close a big win and then open another position with more leverage utilizing only your original investment dollars so you can put profits in your pocket.

This is called "rolling" a position, which gives you the opportunity to raise some capital by closing a profitable position and "rolling" the original investment dollars into puts with lower strike prices and/or later expiration dates.

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 of 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.

For example, we booked a 106% gain in Martha Stewart Omnimedia but our Alliance research indicates that the fun (for us, not for her!) is just getting started. So, we pocketed our $3.30 gain and put our original $1.60 investment toward puts that would keep us situated on the short side for a few extra months.

Not surprisingly, within just a few days, the new puts went up 137%. Instead of leaving that on the table, we cashed out of those, too, and put on yet another position.

Rolling a position is similar to staying in a long stock for as long as you want to be in it, but with a little more active management and attention. And if just a little more work can yield a lot more profit, I can't think of a better case to make for how you can't afford to NOT be investing on the short side!