Michael Shulman

5 Short-Side Investment Rules

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Second rule -- A short position is always based on fundamentals as though it were a long-term position on the long side

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 in companies, and its pundits often pooh-pooh less-than-stellar stock performance as temporary. And my tried-and-true method of making money on the short side is to get situated on the short side 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.

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.

Third rule -- 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 that 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, 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 there.

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 go for the biggest ones possible?