A successful short seller combines a sober eye for fundamental value with aggressive market timing instincts. An investor who sells short needs an analytical understanding of how to value a company's business in order to identify overpriced stocks. A short seller also needs to seize the opportunity when the price dynamics signal a selling opportunity. A successful short seller combines the traits of a long-term investor with a short-term speculator by using his or her skills and understanding of financial statement analysis, industry knowledge, financial projections, money-management, price trend recognition, risk-reward analysis and emotional discipline to identify and profit from short selling opportunities.
The task faced by a short seller is extremely challenging. To better understand the difficulty, imagine that you are trying to predict when the ground you are on will slope downward. Imagine you are trying make the prediction after you are suddenly placed on the lunar surface. You are able to look only straight ahead. You can move only by walking backwards. You see that you have been placed in a broken, hilly terrain that is steadily increasing in elevation. At some point, as you walk backwards, you will place a sizable bet that as you continue to walk backwards you will wind up at a lower elevation. If you are correct, you will make money. If instead you continue to head uphill, then you will lose money. How can you, in this situation, predict with confidence that as you continue walking you will head downhill?
This is similar to a short seller's uncertain position. A short seller can only see what has happened in the past, but must try to predict the future. The stock market is very choppy, but stock prices have tended to rise over time. Like the lunar explorer trying to predict the ground's changing slope while blindly walking backwards over unknown terrain, the short seller must try to predict prices while heading blindly into an uncertain future.
The lunar analogy provides a clue to a strategy for the short seller. The lunar explorer would probably feel safest predicting the ground would continue to slope downward when he had reached a point much higher than the surrounding terrain but then had started moving downward. Similarly, a short seller can be most confident of a successful short sale when she sells a stock that is priced very high relative to other stocks and the price is starting to move down.
The short seller will develop an appreciation of the many elements that need to be in place for her to be reasonably confident that the price of the stock she shorted is going to fall. Before she can place a short sale with confidence, she will need to find satisfactory answers to questions of valuation, market perception and timing.
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