Top 5 Rules for Playing the Short Side

By Michael Shulman

Whether you're shorting a stock the traditional way or doing it the smart way -- through buying 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."

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Rule No. 1: 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.

A stock may be a fundamental disaster, but when cash flows into it -- say in the form of private investment capital -- the smartest thing a short-side investor can do is to run, not walk, in the other direction.

Rule No. 2: A short position is always based on fundamentals as though it were a long-term position.

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 about companies, and its pundits often pooh-pooh less-than-stellar stock performance as temporary. So, 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.

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.