How to Cash In Even When a Stock Tanks

By Dr. Steve Sjuggerud, President, Investment U
Monday, December 29, 2003: Issue #301

Everyone wanted to own shares of Crazy Eddie…

After rising dramatically, shares of Crazy Eddie (the now-infamous consumer electronics chain) doubled from $20 to $40 in just a few months.

The brokerage firms were gushing over Eddie’s prospects.

But then Crazy Eddie himself – a.k.a. Eddie Antar, founder of the franchise – disappeared. The story quickly got ugly, and as quickly as Crazy Eddie went up, Crazy Eddie went down – and out of business.

While many investors lost a great deal of money, those who bet on a decline in Eddie’s share price made a mint. Those who sold short at $40 and bought back in at $2 made a $38 profit on Crazy Eddie a 95% gain!

The ability to do exactly this – to profit from the downs as well as the ups of stock moves – might just prove to be an extremely valuable skill in the coming years. Quite frankly, I’m concerned about the future of stock prices over the next few years.

So today we’ll learn how to maximize our gains when stocks tank – from one of the masters of the short sell. Plus, I’ll supply a word of caution that every new short seller should keep in mind.

A Wonder-Woman Short Seller

She averaged a 15% gain a year on her short positions during the great bull market that ended in 2000.

Sure, 15% a year may not sound like much. But when you understand that Dana Galante made that money by swimming against the greatest tide in stock market history, you can understand that she must be great at what she does.

So how does she do it? Here’s what Dana has to say:

“I look for growth companies that are overvalued – stocks with high P/E (price-to-earnings) ratios.”

That makes sense but I’ve seen many growth stocks that are overvalued become even more overvalued much more.

“There is another key condition,” Dana continues. “I won’t short a stock that is moving straight up. The stock has to show signs of weakening or at least stalling.”

Okay, so that’s simple as well. Look for an overpriced growth stock whose price trend has begun to stall But there must be more to it.

It turns out Galante looks for one more thing: any catalyst – whether it be a market force, a corporate scandal, or some other bad development – that makes the stock look vulnerable right now.

Question: Can You Name A Famous Short Seller?

While short selling sounds easy when Dana Galante tells it, the reality is, it’s difficult to do successfully.

In general, I’m of the belief that longtime market commentator Richard Russell is right when he says, “In a bear market, he who loses the least wins.” Russell is essentially arguing against short selling, and in favor of protecting what you’ve got.

Chances are you can’t name a famous short-seller. There’s a good reason for this there aren’t many out there. Success stories like Dana Galante’s are rare. Anyone that might have been good at it was probably knocked out of it in the great bull market from 1982-2000.

Two of the Market’s Legends Were Also Legendary Short Sellers

You can be knocked out in a variety of ways when you’re attempting to profit from a fall in the share price. Chances are a stock is not going to go from $10 to zero in a day. But it could go from $10 to $20 or higher in one day wiping you out on that position.

It just seems much easier to make a 50% profit on the upside than the downside it seems easier for a stock to rise from $10 to $15 than it is for that stock to go from $10 to $5. Is that true? Or am I being biased by 20 years of good times?

Yet, the day of the short seller may just be coming around again. There have been many famous short sellers in the past. In fact, two of the greatest stock market speculators in history – Jesse Livermore and Daniel Drew – probably made more money by shorting stocks than by buying them.

After the longest bull market in history, it may be time to consider learning more about profiting on the downside. To get on your path to becoming a great short seller, start with the first book I recommend below as a starting point.

Good investing,

Steve

Comments

**By submitting your comment you agree to adhere to our Comment Policy and Privacy Policy.

Check out our selection of daily Investment Research: