Masters Series: My Strategy for Successful Short-Selling

Editor's note: Porter has said one of his great accomplishments as a businessman was hiring Jeff Clark.

Jeff is a master trader. Before joining Stansberry & Associates, he spent more than 20 years managing money for some of California's wealthiest people. Now, Jeff shows subscribers the options-trading techniques he used to help build these people's fortunes.

In today's edition of our weekend Masters Series… Jeff shares his secret for shorting stocks.

Many investors are reluctant to try shorting… They worry that it's complicated or just "not for them." But short-selling is simply a transaction that profits when a stock's price falls. And it's an important tool for a balanced portfolio.

In the following piece – originally published in a 2009 edition of our daily e-letter Growth Stock Wire – Jeff describes three key factors he looks for in a short-sale candidate.

My Strategy for Successful Short-Selling
By Jeff Clark, editor, S&A Short Report

When I first started trading stocks, I did so almost exclusively from the long side... only buying stocks.

Through a series of trials and errors, I developed a three-pronged approach for what constituted a good stock to buy:

As simple as this buying strategy might seem, it has produced superior returns...

Logically, then, it makes sense to use a similar three-pronged approach to betting on a stock falling – called shorting.

Let's look at each element individually...

1. Ridiculously high valuation.

We all understand that, ultimately, earnings drive stock prices. Consequently, the price-to-earnings (P/E) ratio is the best gauge with which to measure the ridiculousness of a stock's valuation.

If you've found a stock with a P/E ratio 50% higher than the industry average, or more than 50% higher than the company's historic P/E ratio, then you might have a good short sale on your hands.

2. High degree of optimism surrounding the shares.

If every analyst on Wall Street loves the stock... if the anchors on CNBC seem to be mentioning the stock every hour... if all of your friends are talking about the fortunes to be made by owning the stock... it's probably on my list of short-sale candidates.

This concept is easy to understand. If the whole world is in love with a stock, and if everyone who wants to own the stock already does, who is left to push the price higher? If there's no one left to buy and to push the stock higher, it only takes one seller to shift the momentum in the other direction.

3. Price action that has just turned down following a steady incline or parabolic rise.

Just as it doesn't make much sense to jump in front of a moving train, it doesn't make much sense to short a stock as it's moving higher.

Rather than trying to pick a top in a stock, it makes far more sense to wait until the price action has turned lower – and is in the early stages of a downtrend. For me, that confirmation occurs when the stock trades below its 50-day moving average.

Stocks in which the upside momentum is strong will hold above their 50-day moving average lines. Failing to hold above that line is an excellent early indication the momentum is shifting to the bearish camp.

You see, all of the Wall Street hype, all of the CNBC promotion, and all of the persuasive opinions of friends at cocktail parties creates big opportunities for us to bet against over-hyped stocks.

If you stick with these three guidelines, you'll have all the tools you need to make money on the short side of the stock market.

Best regards and good trading,

Jeff Clark

Editor's note: Jeff Clark is among the most successful options traders we've ever met. Since joining S&A, he's built a loyal following by showing readers how to use safe options trades to generate big short-term gains. Now, he's developed a way to make five to 10 times higher gains in gold… no matter what happens next to the price… without relying on stocks, bonds, or bullion. To learn more about Jeff's strategies, click here.