My Guide to Short Selling

Sometimes traders sell short without a good reason. They simply feel a big decline in their bones.

In 1987, I went short soybeans after the price had flown up over $9.00 per bushel. All the traders I knew were buying like mad and offered very bullish arguments for further price increases. By then, however, I had learned many lessons about the hysteria of markets.

Hardly anyone notices the beginning of a bull market. But as prices keep rising, savvy investors get the picture, and soon others turn just as bullish eventually as prices continue to rise in spite of the periodic consolidation that occurs in markets. Everyone in the market is making money, which does not go unnoticed by everyone outside the market, and many more people get sucked in.

Soon formerly rational people are quitting their jobs to become day traders. Wild hysteria rules—and I am shorting. By shorting soybeans in 1987, I was shorting another round of hysteria. The price of soybeans fell, and I made some money.

While shorting hysteria is usually correct, I recommend also trying to have good fundamental reasons for believing that the price is likely to decline.

The speculator’s profit lies in the difference between his original price and a cheaper one. If he’s wrong, and prices rise, he will have to cover his short position by buying futures at the higher price, thus losing money.

And every speculator will get it wrong at one time or another.

I vividly remember shorting oil in 1980. Prices had been rising for years, even though increased production and conservation were building up supplies. In 1978, supplies actually surpassed demand—but prices kept going up, irrationally.

By 1980, I figured the market would soon notice that the fundamentals of oil were completely out of whack and decided to bet against oil. What I didn’t anticipate was that our friend (and he was an ally back then) Saddam Hussein would invade the Islamic Republic of Iran, then run by the Ayatollah Khomeini.

Two members of OPEC in a major shooting war against each other is not a good time to bet that oil prices will go down. In the run-up to the war, I managed to cover my shorts as prices began to skyrocket. (In hindsight I should have hung in there, because oil was genuinely overpriced and eventually the prices sank back down. I had been right about the fundamentals of oil, but I panicked, just like everyone else.)

Here’s my general rule of thumb for shorting:

I don’t like to sell something short unless it’s unbelievably expensive.

And I mean unbelievably. I’ve shorted lots of things in my life that were expensive, only to see them get more expensive.

In my early days on Wall Street, I learned one of my greatest lessons about market hysteria when I shorted University Computing in 1970, selling it at $48 and waiting for it to descend. I ended up covering my shorts when the price reached $72.

University Computing proceeded to go up to about $96—and then plummeted to $2.

I was right to short the stock, but I still got wiped out, because, at the time, I didn’t have the guts or the money to stick with my convictions that the stock was way overpriced. I was a lot smarter during the dot-com bubble, but I suspect a whole new generation of young wizards learned a similar lesson shorting tech stocks that kept rising into the stratosphere for no good reason at all.

A fledgling tech company that was clearly overpriced and a classic candidate for shorting, JDS Uniphase went from $20 to $129 in a year. The trouble was that the market wasn’t paying attention to real value. Newcomers to the market who thought it was a never-ending gravy train piled on for the ride.

Incredibly, JDSU had more than another $20 to go before it plummeted to $80, climbed toward its high again—and then headed south to almost zero, where it stayed for the next three years.

When gold was moving from $100 straight upward in the 1970s, a rational investor might have considered shorting it at every 100- point rise. Was there anyone at $150 betting it would go straight to $860? (I didn’t short gold back then, but I did sell it at $675, way too early, of course, but the top came in about four more days.)

And when sugar went from 4 cents to 40 cents, also in the seventies, I suspect that many thought that commodity was unbelievably expensive. Unfortunately for those who shorted sugar at 40 cents, the price went over 66 cents before it fell back to reality.

As you may have noticed, futures trading is a humbling vocation. Every trader must come to terms with losing, because all traders lose. In fact, most traders lose most of the time.

It’s the bottom line that counts—winning more than you lose.

Good investing,

Jim Rogers

- From Hot Commodities

Editor's Note: Jim Rogers has been described as the Indiana Jones of finance. He’s been around the world on a motorcycle. He’s founded a hedge fund with George Soros, he’s taught finance at Columbia University's business school and he’s written three classic books on investing. He lives in New York City with his wife, Paige Parker, and their daughter, who is learning Chinese and owns commodities but doesn't own stocks or bonds.

The essay you just read was taken from Jim's recently released third book, Hot Commodities: How anyone can invest profitably in the world’s best market. You can order a copy here: Hot Commodities.