Top 5 Rules for Playing the Short Side

By Michael Shulman

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.

Rule No. 3: 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 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, then 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 shoot for the biggest ones possible?

My point here is that 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 looking for 25% gains, you may be better off sticking with stocks.

Rule No. 4: 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.

Rule No. 5: 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 in 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.

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 why you can't afford to not be investing on the short side!

Michael Shulman is the Editor of ChangeWave Shorts.