How hedge fund managers find short selling stocks

What is short selling?

Short selling, or ‘shorting’ as it’s often referred to, is an investment strategy used by many institutional investors, such as hedge funds, whereby the investor profits on the declining value of a stock or security. This is in direct contrast to the more traditional and reasonably simpler form of investing, where investors profit from the increasing value of a stock - also known as taking a long position.

In some cases, investors may open a short position to hedge against short-term risk on an outstanding long position on the same stock. On the other hand, shorting can be used by institutional investors to turn a profit when they believe a stock’s value will fall.

To short a stock, a hedge fund will borrow shares of the stock in question (usually from their prime broker) and sell them to other investors who are willing to pay the market price. Then, as the stock price falls, the hedge fund will buy the same shares at a lower cost and pocket the difference.

However, if the stock price goes up the hedge fund could face hefty losses, which is why committing to thoroughly researching and analysing the stock and broader market, before opening a short position, is crucial - particuarly for hedge fund managers looking at the benefits and risks of short-selling stocks.

How do investors find short selling stocks?

While short selling comes with its own unique set of risks, when done the rewards can be great. However, being able to spot an opportunity to short a stock is a skill in itself and is very different from finding an asset that has the potential to deliver profit on a long position. As such, hedge fund managers usually consider a range of fundamental and technical factors when looking for new stocks to short.

Fundamental factors

As a starting point, short sellers will look at the business behind a stock to determine whether they believe it to be overvalued. To do this, they first consider whether the service or product it offers is outdated. This could be the result of a shift in consumer demand, or it could be that a new and more profitable business has emerged, similar to how Netflix outgrew Blockbuster.

Taking a closer look at the company’s fundamentals, short sellers will assess a business’s accounts to see if there are any irregularities.For example, before GameStop became a ‘meme stock’, Chewy co-founder Ryan Cohen bought a 10% stake in the company and wrote an open letter to its management saying it was ‘one of the most shorted stocks in the entire market, which speaks volumes about investors’ lack of confidence in the current leadership team’s approach.’

Along with factors intrinsically linked to the asset in question, there are other considerationsinstitutional investors will consider before shorting a stock.

Trends and technical indicators

The best time to start shorting stocks is usually during a bear market, which is when the majority of stocks in a sector or market follow a downward trend. It’s no surprise then that during a bear market the chances to make a profit from shorting assets are far greater than during a bull market, when the general trend is going up.

While there’s no exact science to predicting which way the markets will swing, there are several key technical indicators that hedge fund managers use to gain a better understanding of whether markets are likely to follow a bullish or bearish trend.

The use of technical analysis to detect profitable shorts usually involves looking at indicators such as a relative strength index (RSI) or a stochastic oscillator, which help determine whether an asset is overbought – and therefore overvalued. Seasoned short sellers will also look at a trend indicator, such as the moving average, to further determine the value of the security they’re considering as a short has room to fall.

Put simply, when it comes to short-selling, an oscillator can be used to detect a stock or security that’s peaked and is less likely to attract new buyers. Meanwhile, trend indicators are used to show when the support level of an asset has broken and is likely to continue falling.

Short selling is a complicated and high-risk trading strategy, but the rewards can be lucrative can be mastered, provided the hedge fund manager and their team have the appropriate market knowledge and resources to make such a trade. It’s vital, however, to do intensive research before opening a short position. This alone will greatly increase the chances of making a successful short.