Three Strategies Every Short Seller Must Know

In the last installment of The Finance Professor, I explained the mechanics and operational aspects of short selling. Now I want to address short selling from a trading and investment perspective.

There are several factors that will motivate a trader or investor to short sell a security . Here are the three main strategies and the reasoning behind them.

1. The Valuation Short

I discussed the concept of fundamental stock trading in an earlier lesson. To review, fundamental research on a company will typically result in earnings estimates which then translate into a price target. When this is accomplished we can then compare our price target to the current stock price . If the stock is below its price target then we will usually be inclined to buy the stock. However, if the stock is above its price target we might avoid or sell the stock, if we owned it. In some instances, the price target is significantly lower than our price target and the short sale of that security might be in order. For example, say that you value a stock at $40 and it is currently selling at $50. According to your analysis, selling short the stock at $50 will yield a $10 profit if the stock hits your lower price target.

Why would you institute a valuation short? There are two potential reasons. First, you may come to the conclusion that current earnings estimates are inflated and the stock is priced on improper assumptions. Second, earnings growth may be slowing, which will result in price-to-earnings multiple compression. As a current example of this, I have recently sold Starbucks (SBUX Quote) short in anticipation of declining earnings and growth rates .

Valuation shorts are very dangerous because expensive stocks can become more expensive. This strategy should not be used recklessly. Take for example Amazon.com (AMZN Quote), a heavily shorted stock. The company may appear to be too expensive because it trades at 100 times its current earnings, but that has not deterred investors from ramping the stock even higher. Remember, as economist John Maynard Keynes said, "The market can stay irrational longer than you can stay solvent."