Some things just do not need to be that complicated when it comes to defining market terms. So going back to basics, you know that you can buy and sell stocks of companies. Being “long” of a particular stock means that you buy the stock and you think the value is going to increase. There are lots of reasons to think why a stock might increase in value, but that’s not important right now.
To short a stock means that you sell the stock because you think the price is getting ready to decrease. So on the most basic terms possible… you buy a stock thinking that the price is going to go up and you “short” the stock if you think the price will go down.
So how do you know when to short a stock? Well if you have visited Residual Income Life before then you know that there is no substitute for research. Here are some things you are going to want to investigate.
Company Financial Statements
Company 10K: This is an annual report that allows you to look at virtually any specific information you need for that company.
Company 10Q: These statements are released every quarter as a financial summary of the company.
Cash Flow: Can you identify where most of the money is going?
Cash Generation: Can you identify where most of the money is coming from?
Almost all of this information can be found at one place: http://sec.gov/
Looking at these reports has a very specific purpose. You are attempting to determine the general standing of that particular company. Companies can do a lot of questionable things as long as they are reported at the appropriate times so most of the time some key information is in black ink, available for anyone who takes the time to read it.
One thing to look for is are they generating cash from their everyday operations or are they generating money by selling off assets? If a company is accomplishing everything by creating massive amounts of debt, this is a great indication that not everything is as they appear. That may be that is a company that you’d want to short because that is a bad sign for them that if they are not generating revenue or cash from their core business.
Another important aspect of research besides financial statements involves using simple logic and reasoning. I like calling this “going with you gut” as well as the financial records. Maybe a LOT of people are long of a company that they think has all the potential in the world based on finances alone. However maybe you see a fundamental flaw in the scalability of the company or you just see their business structure as too unstable.
A great example of this is Netflix. Netflix provided an awesome service for a long time. They would mail DVD rentals to your house instead of you going to the local video store to check out and then return a video. It was a brilliant model that made them a lot of money. But things changed and eventually the company had to face the fact that they needed to start streaming their content online to stay relevant. This went really well for a while but as demand for streaming increased the costs for the companies streaming rights got higher and higher. They eventually had to pass those costs onto the consumer and they received a lot of criticism and unsubscribes because of this. As a result Netflix plummeted over $200 dollars a share. Wow. Not a good time for all the people who were long of Netflix because they didn’t do their research and didn’t think logically about the big picture for the company.
Thanks so much for reading and as always feel free to email me at chris@residualincomelife.com with any additional questions.
Or leave me a comment below!
Thanks,
-Chris
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