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Advanced Strategies for Stock Market Speculators
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Most of my financial life I have worn two hats: I'm a practitioner and a real-time explainer of what I am doing to those trying to learn. I try to put the process in English, so that you aren't confused by the mathematics or the science of it. I try to make it simple because so many people in my business try to make it hard. They use Genuine Wall Street Gibberish, a form of mumbo jumbo; wittingly or unwittingly, they seem to do their best to confuse. I know when I was a salesperson, I could take advantage of those who were ignorant of the way we on Wall Street work if I wanted to be short-term greedy. Those who knew the most and had the best facility with money, though, did get the best treatment and benefited considerably versus those who just couldn't figure it out.

Most of what I had to explain would make sense to anyone who has more than a fifth-grade education: Stocks are arithmetic; the logic behind them is psychology, not quantum physics. Buying and selling a stock is no different from buying and selling a house. You are m&ng money if it goes up after you bought it; you are losing money if it goes down. But there are two parts of what I did with securities as a practitioner that are particularly difficult to fathom and execute: options and shorting. For these there are no easy explanations, no fifth-grade analogs that make them more understandable. But they should be learned nonetheless. Why should you not be able to take advantage of all of the instruments and methods that the most advanced players use simply because they are complex and arcane? They can be incredibly valuable even to novices if used correctly. They might help you as you get started in building a winning portfolio, regardless of the environment.

Shorting is difficult to understand and potentially dangerous. It's difficult to understand because shorting involves selling something that you don't own. You can't do that in any other line of business. You can't sell a glass of lemonade you don't own, you can't sell a home you don't own, and you can't sell a car you don't own, so it's incomprehensible to many how you can sell stock you don't own. How do you deliver to the buyer shares you don't own? Where do you find someone willing to give it to you so you can sell it without owning it? How about if you first borrow it from your broker before you sell it short?

Let's go through the hypothetical. Let's say you think Intel's too high and you want to profit from the decline you expect to happen. When you sell a stock short, you say to your broker, "I want to sell one thousand shares of Intel short.'' The broker borrows the stock for you first, places it in your account, and then sells it for you from your account. You even get the proceeds from the sale of 1,000 Intel right into your account. If the stock goes down after you sell it, you make money, the mirror image of what happens when you buy a stock and it goes up. Of course, the opposite is true, too: If you short Intel and it goes higher, you are losing money.

When you buy the stock back that you shorted you are "covering" the short, and you should say that in the order so the broker knows exactly what you are intending. Let's say you sold 1,000 shares of Intel short at $20 and it drops to $16. You tell your broker, "I want to cover the Intel short, I want to buy back one thousand shares of Intel." If you buy back the stock at this price you make $4,000. Ah, but what if Intel went up? Then you could cover for a loss, as in, "I am covering the one thousand Intel I sold short at twenty dollars at twenty-four dollars : ' where you would lose $4,000. You could always continue to battle the Intel and sell more, or you could just let it run; that's up to you. But be careful, you can lose lots of money if the stock keeps going higher. The loss or the gain isn't booked until you cover the trade.

Shorting is dangerous because stocks can only go down to zero but in theory at least they can go up to infinity. That's a terribly asymmetrical risk-reward, one that could allow you to lose millions of dollars as a stock goes up and up, but make only a finite amount as the stock of even a bankrupt company stops at zero-—although some stinkers I owned felt like they could go even lower.

It's tough enough when you own a stock and it goes down, but it's excruciating when you are short a stock and it goes up. It's financial suicide when you short a stock that so many other folks are short, and the brokerages can't find the stock in the vault to lend out because all shares are out already. The seller can never fail to deliver. So the brokers have to go into the open market to find stock to deliver to the buyers. Their frantic buying creates a squeeze that can produce wild gains for the longs and stupendous losses for the short sellers. That's why such moves are called short squeezes. Stocks can zoom when a large percentage of the "float : or shares that can trade freely, are sold short and new short sellers come in and fail to locate borrowed shares before they sell. That's illegal—you always have to locate stock first—but lots of bad brokers let it happen because they want the commission, and lots of stupid customers don't tell the broker up front that the sale is a short one. When the unscrupulous meet the uninformed, and execute short sales of stocks that shouldn't be shorted, it's a combustible combination. Often these squeezes happen to the phoniest of stocks, so that you could be right on the fundamentals but be betrayed by the mechanics of shorting. The shorting process entails too high a degree of difficulty and risk for the vast majority of investors because you can lose more than you have in your account if the shorted stock skyrockets. It's particularly awful to short a company many know is phony, because the real bad ones are so often targeted by multiple short sellers. That's why occasionally you see these counterintuitive 10- and 15- and 20-point jumps for stocks of companies that barely exist or are simply hype. So be very careful before you sell short. If you want to save yourself some stress and put a cap on your losses up front, you should first try to bet against the stock using put options.

Options are hard to explain. I have never met anyone who could explain these complex instruments in a simple way. So I will tell you that their degree of difficulty is beyond the average investor's ken. Options have their own language—"calls" give you the right but not the obligation to buy common stock, while "puts" give you the right but not the obligation to sell common stock. They also have their own rules—you need to decide to exercise or sell them when they are "in the money" at expiration. If they are misused they are extremely dangerous.

So why go into options at all? Lots of reasons. First, you are almost ready to go out on your own and nab some higher returns using the tricks of the trade I have taught you. But I don't want you going out there without knowing all of the weapons that can be in your arsenal. The main reason you bought this book is so that you could learn how to be better at handling your money, better at being a good investor or a good client. No one is going to care about your money as much as you do. Part of being a wise investor is being familiar enough with all the conventional and unconventional strategies so you can be sufficiently knowledgeable to evaluate your broker, decide if he or she is right for you. You need to retain control and not lose it to someone who might do wrong things to or for you. I have learned the hard way that bad brokers and bad managers use fear and ignorance to milk nayve clients. If you don't understand options I believe you will get ripped off by someone who recognizes your ignorance and tries to take advantage of it. Further, options are part of sophisticated but sound stock analysis. Investors need to know—at least in general terms—how everyone is betting on a stock before they buy shares in it.

I understand that options can be intimidating. I have met seasoned common stock traders, people who have traded common stock for decades, who don't understand what puts and calls are and why anyone would use them. These are complex pieces of paper (also known as "derivatives") that allow you to use a little capital to go a long way. You buy calls when you want to make a bet that a stock—or an index—is going to go higher in a short period of time. You buy puts when you think a stock or an index is about to sink quickly. You buy them like this: "I want to buy calls on Intel" or "I want to buy puts on Intel." Then the broker offers you a menu of options struck at various prices at various months out in the future. He asks you how many you want, with every option equal to 100 shares of common stock. (Don't worry, I will walk you through examples.) The puts or calls are entered into your statement in the same way that common stock is. They don't obligate you to do anything, though, and the vast majority of all puts and calls expire worthless, meaning that the owners and holders lose money on the bets. You never have to use either puts or calls. You can always buy common stock or -a basket of common stocks if you want to profit from the upside. You can always sell a common stock or even sell all your stocks when you think that the market's going lower. My wife, for example, never understood options. She used to rail that if I really hated the market, what the heck was I doing buying insurance against my stocks in the form of puts, or contracts, that give me the right to sell the stock at the current price ("in-the-money" put) or at a lower price than it currently sold at ("out-of-the-money" put). She would tell me that stocks aren't houses; you don't have to live in them. Why insure something you don't have to live in? Just sell it. That's not bad advice.

These days, because I am limited by various media obligations, I can't use puts or calls. If I think a stock is going to go down, I just sell it; I don't buy puts on it to protect it. But I used both puts and calls to tremendous effect when I first started out as a little investor and ultimately at my multi-million-dollar hedge fund. Over the years I found that options were a fantastic way to make a little money into a lot of money. As I am a constant risk-reward hunter, I loved the idea that I could risk some money on calls to make much bigger money than I could make buying common stock. I also loved the idea that I could bet against a stock using puts without worrying about a short squeeze, where a stock rallied hard because so many others were mak­ing the same bet that brokerage houses couldn't find any more stock to borrow.

I have wrestled with this chapter more than the others because I know that the stuff I did with options in my later career may simply be too difficult and time-consuming for all but the most hard-bitten professionals. Yet I know I have to expose you to them, just so you can understand what's out there, so you can understand what to do if you ever have a hunch so good that it is worth speculating on. I've had a ton of these and I am always grateful that someone came up with options so I could take advantage of their bang for the buck. Let me walk you through how options work and how they differ from purchasing or selling common stock so you can understand their magic. Then I can present you with some advanced strategies about how to use options in a conservative way to leverage your cash and your best hunches.

As mentioned, there are two kinds of options, calls and puts. Call options are the right but not the obligation to purchase an agreed- upon amount of stock at a particular price in the future. Put options are the right but not the obligation to sell a stock at a particular price in the future. We buy calls when we have a hunch that something big is going to happen that's terrific for a stock or for the market. We buy puts when we think that a stock's going to implode and we want to be there, gaining from the collapse, rather than just being blasted out of our wealth. We can buy puts or calls on stocks or indices. Don't like the NASDAQ? Buy a put on the QQQ, the Nasdaq 100. Like the Dow? Buy Dow Jones calls. Think the overall S&P 500 is going higher in the near term? Buy a call on it. Worried that the market's about to dive? Buy puts on the S&P 500.

You can buy a call or a put like a regular stock. The difference is that when you buy a put or a call you are buying a bet on the direction of the stock; you are not buying the stock itself. You have to be able to isolate the time frame that you want to bet on that appreciation or depreciation before you buy one. You can't say, "I want a put that will last forever" or "I want a call that will never end" because these are con­tracts with a delivery date. And you have to predict where the stock will appreciate or depreciate to, an actual level that you think it will go to. In other words, you can't just say, "I want an Intel call." You have to say, "I want a call on Intel that will allow me to capture the apprecia­tion of the next ten points over a period of, say, eight months." If it is February and Intel is at 20, your broker or your electronic screen will give you a list of calls that would reflect that time period. He might suggest that you buy the "October 20 calls," phrased that way because it would mean that you would have until October of that year to capture the appreciation. The "20" is the "strike," the price level you are paying for all of the points Intel might make above 20 by the third week in October (all options expire on the third week of the month). Let's go through the hypothetical.

It's February and Intel's at $20. Let's buy some Intel October 20 calls. You pick up the phone and you say to your broker, "I want to buy some October 20 calls on Intel." The broker would then look up on his options monitor—they all have them and you could have one too, if you wanted to—and the broker might see that the calls are at $ 1.75 bid $2.00 ask, meaning that you can sell or buy an October 20 call at those prices respectively. Let's say you want 10 of them. That will cost you $2 per option. Each option allows you to buy 100 shares of common stock at $20. The arithmetic is a tad difficult to remember, because you have to multiply that $2 by 100 first. Then you have to multiply the sum of $2 times 100 by the number of calls you are buying. So, 10 calls costs $2,000 ($2 X 100 X 10 = $2,000). There are no shortcuts for un­derstanding this process. You must know that the $2 price is the start­ing point to calculate the amount you are spending. If you can't follow it, work with your broker to figure it out.

Let's say Intel goes to $25 in October. Your Intel October 20 call, which you bought at $2, is now worth $5. How? You simply subtract the strike from the price of the stock to figure out what the call is worth when it expires. Congratulations, you have paid $2,000 and you have something now worth $5,000. You made $3,000 betting that Intel would go up.

But let's say you feel Intel is going down, not up, during that same period. You might want to buy the Intel October 20 puts, which would allow you to capture all of the depreciation below $20. Again, with the stock at $20 in February, the October 20 put may cost $2. You buy 10—each put allows you to sell 100 shares of Intel stock—for $2,000. If the stock drops to $15 by October, you subtract the closing price from the strike to figure out how much you have. Twenty minus fifteen is five. The $2 puts you bought for $2,000 are now worth $5,000. Congratulations. You made $3,000 betting against Intel.

Who determines the price of the puts and calls? The thousands of buyers and sellers of these instruments. Institutions sell calls and puts to bring in additional income. Individuals and hedge funds, the type of fund I used to run, for example, buy them to magnify bets, to put a little capital to work to make a lot. They determine prices for puts and calls much like stocks through the marketplace, as a function of supply and demand. You can get posted prices for small increments of puts and calls from your computer screen. Consult your broker if you want to buy more than a 10 lot, though, because the screen market may not be big enough for more than that.

Options are quite handy, and most of us have used them; we just haven't used them to buy or sell stock. When we speculate in real estate, we often ask for an option to buy something. We pay for that option even if we end up not buying the land underneath it. When we buy insurance, we are buying a put. We are putting out a little money to protect a lot. We don't want the insurance put to pay off, but if it does, we consider ourselves lucky to have had it. The insurance put and the real estate call are just like stock options in their most basic form.

Let's flesh out the real estate call so we are more comfortable with examples that look and feel a lot like options that you are familiar with. Let's say you live in a town near a heavily traveled interstate highway. You have a hunch that sometime in the next year or two, the fed­eral government might build an off-ramp not far from where you live. You recognize that when off-ramps get built, retailers flock to these sites as natural places to erect new stores. You, yourself, are not a developer and have no desire to develop the land. You may not even be able to afford the land—far from it, in fact. But you don't want to miss this chance. It would be natural for you to call a Realtor and say that you would like an option to buy the land for the next two years, if one were available. That way, if the off-ramp is proposed, you know that you can exercise the option and sell the land, perhaps to a Target or a Wal-Mart, for a heck of a lot more than anyone thought possible. Let's put some numbers on it. Let's say the parcel of land was for sale for $300,000. You didn't have that money on hand. It is possible that you might be able to propose that for some percentage of that $300,000, whatever you think negotiable, perhaps $ 10,000 a year, you reserve the right to buy that property for $300,000. If you could get that option contract and the off-ramp is approved, you might be able to exercise that option and, without ever putting down the $300,000, sell it, say to Wal-Mart for $3 million. You just made an astronomical profit by exercising the option and selling it.

That's how I got started using call options. I wouldn't have the money that I needed to buy a lot of common stock, but I could put a much smaller amount of money down in order to buy the common stock some time in the future at a fixed price, and then sell the option, or exercise the option and sell the common stock afterward. Let's walk through an actual trade so you can see how I was able to use call options to make a ton of money in a legal way.

At the time I was doing my canvassing, Merck traded at $80 a share. If I wanted to buy 100 shares of Merck, I would have had to pay $8,000. That's a lot of money to put to work for a limited amount of shares, especially because—as in that case of the real estate by the off-ramp—I didn't care to own the actual stock; I just wanted to own the appreciation of the stock. I just wanted the upside from $80.

How about if I could buy a right to the appreciation of Merck, just the appreciation of Merck, not the stock itself? What if I could get someone to give me an option on the appreciation of Merck above $80, given that I thought Merck would jump in the same way that the undeveloped parcel of land might jump? That would be a better way, especially given that I knew when the drug was going to go to market and that it would immediately impact the sales estimates, which, theoretically, would drive the company's stock higher.

So, naturally, I asked my broker for a call on everything above $80. Here's where the fun begins. He would say, "I can offer you a contract that will allow you to get all of the appreciation above seventy-five dollars, or above eighty or above eighty-five or above ninety or even above one hundred? Which one do you want?"

You want to know how much each option costs and how much you can buy above each one. You want to figure out which has the most value, the most bang for the buck and the least likelihood that you will lose it all. Let's play it out conversationally, the way I have had to explain it to hundreds of customers.

"I would like the call that begins at eighty dollars : ' the first-time options customer says.

"And when do you want your contract to last to?" I, the broker, would ask.

Given the time frame of the new drug's launch, the customer says, "I need to have the option last until at least February."

I would then scroll through the menu of Merck calls that are currently being made on one of the big options exchanges and suggest as a start, "We should look at the Merck calls that last until the third week of February." Let's consider the Merck February 80s, shorthand for Merck calls struck at $80, meaning that you get all of the appreciation above $80 until the third Friday of February.

"How much will those cost?" the customer asks.

I would then tell the customer, before I mentioned the price, that each call is the right but not the obligation to buy 100 shares of stock above $80, so I would be quoting a dollar amount that would be multiplied by 100. Confusing, I know, but a call doesn't equal 1 share of stock, it equals 100 shares. So I would say, "Each call is priced at five dollars, so you would have to spend five hundred dollars per call."

Now, the customer thinks, Hold it, the call costs me $5, that's a lot of money. "If I buy this call, if I buy one call, and Merck goes to eighty- five by the third week of February, how will I have done?"

Not too well, I say. You are spending $500 for the right to buy 100 shares of Merck above $80, but that right will make it so you make no money until Merck goes above $85—the $5 you paid for the call plus $80 equals $85. You will be wagering $5 to make $5 unless it goes higher than $85.

How about the calls that allow me to get everything above $85? the customer would then ask.

"Those," I would say, "are three dollars per contract, meaning that you would get the appreciation for one hundred shares above eighty- five dollars but that would cost you three hundred dollars. Now the stock has to go to eighty-eight before you start making money." (I am approximating what the prices would be, but you get the picture.)

Most of the time you might just say at that point, Wait a second, this is too expensive. I am not going to risk all of that cash and then watch Merck go up 5 or 8 points and make nothing. I would rather take that $500 or $300 and buy the common stock. Of course, you can see the problem with that. You don't get a lot of Merck stock for $300 or even $500. You buy three shares of $80 Merck stock for $300 and it goes up 5 points, you've made $15. That's not much at all. You buy six shares for $500 and make $30.

But let's say the customer is adamant that this new drug is going to shoot the lights out, as I was. I believed that Merck could go to $100 by February. So the customer comes back and says, "I have eight thousand dollars to invest in Merck calls. You tell me what to do. I think the stock will be way above a hundred come February."

I would test the customer's confidence. If he sticks to his guns, then I would say, "Okay, you have great conviction. Let's look at the Merck calls struck at ninety dollars. They are one dollar per contract, meaning you can buy, for one hundred dollars, all the appreciation above ninety dollars for one hundred shares. You can either buy one hundred shares of Merck stock for that eight thousand dollars or you can buy up to eighty of the Merck nineties for that eight thousand dollars." (Remember, each call must be multiplied by 100 because each call represents 100 shares. So a dollar call costs $100 and with $8,000 you can buy 80 calls.) If you buy 80 of those calls, you will control the appreciation above $90 of 8,000 shares. Each call is the right to 100 shares worth of Merck.

So now let's contrast the two choices, the common stock guy who buys 100 shares of Merck for $8,000 and the options guy who buys 80 of the February 90 calls for $8,000.

If Merck does nothing, stays at $80 for the next four months, what will happen? The common stock guy's doing fine. He has his $8,000 and has probably picked up a Merck dividend along the way—the dividends go only to common stock holders, not call holders. The option holder? He's out all $8,000. Horrible trade. Just horrible. That Merck 90 call went out worthless.

How about if Merck goes to $85? The common stock guy just made $500 on his $8,000 investment. Not bad, not bad at all. Good rate of return. The options guy? He's the big loser again, out all $8,000.

How about if Merck goes to $90? The common stock buyer is now in clover for 10 points, he's up $800, he's made 10 percent on his money. Better than a sharp stick in the eye. The call holder? Still wiped out. All $8,000. How much is the right to buy a stock at $90 worth when the stock is at $90? Nothing!

So far, under every scenario, the options guy is a chump, a moron, a total loser. The common stock guy is the winner, big time.

But how about if Merck goes to $100. Then what happens?

Paydirtfor the call holder.

You own the rights to all of the appreciation above $90. You just made 10 points. You have 80 calls, controlling 8,000 shares! You just made 10 points on 8,000 shares. That's $80,000! Of course you don't have to buy the common stock, you just have to exercise the call when it gets there and sell the common stock.

It goes like this. You tell me, your broker, to exercise the 80 calls in Merck. You simultaneously tell me to sell 8,000 shares of Merck, because when you exercise the calls my brokerage will deposit 8,000 shares of common stock into your account, and you don't have the $800,000 you need to own 8,000 shares of a $100 stock.

In real estate that's the same as selling the land to Wal-Mart with out having to take delivery of the land. You couldn't afford to buy it, but it doesn't matter because you exercise the sale at the exact same time that you exercise your option.

You bought all of the appreciation rights for 8,000 shares of Merck between $90 and $100. That's 10 points of appreciation. Your $8,000 call turned out to be worth $80,000 (10 points times 8,000 shares be­cause each of the 80 calls controls the appreciation of 100 shares, and 80 times 100 is 8,000).

How did the common stock shareholder do? He bought 100 shares at $80. The stock went to $100. He made 20 points; 20 times 100 is $2,000. He made $2,000 on his $8,000 investment. You plunked down $8,000 and saw it go to $80,000. You just made $72,000 on that same $8,000.

Now I've got you interested.

Let me tell you what happened to me in that example. I put about $80,000 on those calls. They went up ten times. And I had enough money to quit my job to go run a hedge fund. I know I could have been out all $80,000, but I thought the reward justified the risk.

I know I have made it sound simple, and it is simple when the stock explodes up. Most stocks don't. Most people get wiped out by what is known as "out of the money" calls. But if you are intrigued, I urge you to consider calls when you know something so special that it might merit such a wager.

Now, let's play the downside.

Let's say Merck's stock has gone to $ 100 and you get a sense that the U.S. government is going to allow people to buy Merck's Mevacor in Canada for one-quarter the price of what it sells for in the United States. That would be a disaster for Merck. You think Merck will go down 20 points when it happens. If you own the common stock, of course you would sell it. But you might be tempted to short Merck, or bet against the stock. You would call up your broker and say, "I want to bet against Merck because of a change I see coming, what do you advise me?"

But, I would quickly add, if you are wrong, you could lose your money. Worse yet, if Merck goes up, you could be out infinite amounts of money. Let's say Merck goes up 10 points. You would owe that 10 points to the guy from whom you borrowed the stock. You'd be out $10,000. And if it went to up 20, you could be out $20,000!

No customer wants that risk. So you might ask for a menu of puts, which give you the right but not the obligation to sell the stock at various prices. I would call up the menu and say that I could sell you a put that allows you to gain everything under $100, under $95, under $90, and so on, as low as you want to go.

The $100 put costs $5. The $95 put costs $3, and the $90 put costs $1. Again, we walk through the mirror image of the call arithmetic. If you buy the Merck $100 put and the stock goes down 5 points, you make nothing. The cost of the put equaled the loss in price of the stock. If you buy the $95 put and the stock goes to $90, you make a little bit of money. But if you buy the $90 put and the stock goes to $80, you could make $10 per put.

So, let's do it, let's buy the $90 put. Here's what happens. Let's keep the investment amount the same, $8,000. You buy 80 puts struck at $90 for that $8,000. Those puts give you the right to all the decline below $90 for 8,000 shares—80 puts times 100 equals 8,000 shares. If the stock goes down only to $90, you make nothing. But if it plummets to $80, you have sold the equivalent of 8,000 shares at $90 and it went to $80. You made ten points times 8,000 shares or $80,000.

Now let's compare the short seller who sells 1,000 shares of common stock at $100. He makes 20 points per share if Merck drops to $80. That's $20,000. Not bad. But he also risks getting crushed if the stock goes higher than $100. Twenty-thousand-dollar gain versus an infinite loss if Merck runs. Not a good risk-reward.

The put holder, though, limits his risk to his investment. He can't lose more than $8,000, and if the stock declines to $80, he makes the equivalent of 10 points on his 800 shares that he controls through the puts. He's up $80,000 versus a loss of $8,000. That's a fabulous risk- reward.

Both of these examples, the put and the call, show the true power of options when they work right. They also show that you could be out a lot of dough when you are wrong. When you know that you have something big, either way, the best way to play it is in puts or calls. But if it isn't big—and about 99 percent of the situations I hear daily aren't big—it is better to use the common stock. It's that last caveat—that 99 percent of what I see and hear should be played in common stock— that keeps me from spending more time telling you about the more tricky and dangerous ways to use calls and puts. We'll have to save that for another time.

Which stocks should be shorted? Anything you think should be going down rather than going up. I don't mean that facetiously. I like to be able to look at or argue every stock from the point of view of a long or short. When associates of mine would come to me at my hedge fund with a long, I would view it as a short seller would, and vice versa. I think it is important to be able to examine both sides and not to be dogmatic about which side to take. Given that predilection, I think what you need more than a list of which stocks should be shorted is a set of rules that exclude certain stocks from being shorted. My wife developed just such a list of basic tenets and I will share it with you. Remember it, write it down next to your monitor, whatever it takes, but don't violate it. I believe that statistically you will be doomed to lose money on a short if you do. These rules have saved me tens of millions of dollars. And as Karen is incredibly plain speaking, you won't have any trouble understanding them.

First, the Businessweek cover rule. Karen would always ask me, Do you think the company could be on the cover of Business Week this Friday as the world's greatest company? Simple rule. Life saver. Don't go after good companies that you think are screwing up short-term. There's nothing worse, for example, than being short Merck, as I once was, and then reading a loving BusinessWeek cover story on Merck three days later. If your short involves a company great enough to be on the cover of BusinessWeek, forget it. Even if you have insight, just forget it. Great companies shouldn't be shorted.

Second, can the company be taken over? If yes, Karen would say to me, "You are on your own, just do it in puts.'' In my career, I've been short three companies that received takeover bids, all at a huge pre­mium: NCR, Systemix, and Genentech. With each one I had what I thought was a great reason to be short. The first two had disastrous fundamentals, as the acquiring companies later found out. The third had traced out a perfect head-and-shoulders pattern (technical jargon for a stock that's supposed to roll over imminently), something I guess Hoffmann-La Roche didn't care about when it made its partial tender at a gigantic price above where I shorted the stock. In all three cases, I must admit, I could have guessed that a takeover could have occurred, as all three companies were in industries experiencing consolidation. I should never have shorted them. This point alone is worth millions of dollars. A possible takeover should transform a short into a put special, or you should just not play at all.

Third, never short because of valuation. Never short because you think the stock's too expensive. Expensive stocks have a way of getting more expensive. I don't care what PIE Qualcomm sells for, I don't care whether you think Yahoo! or Google is absurdly valued. It is irrelevant that some stock that trades at $50 has no earnings. You must never, ever try to call an irrational top based solely on multiples of sales earnings. There will always be some mutual fund out there that will keep the ball in the air and crush you with its buying. Michael Steinhardt, my wife's guru, taught this basic point to her, but repeatedly violated it himself. He lost oodles of money shorting overvalued stocks.

Is there a rational for why this method of shorting doesn't work?

Of course, there are plenty of times when the out years don't mate­rialize, but that's not the point. You have to consider the fact that other investors might believe that they might materialize. You need a better, more rigorous answer about why a stock will come down than "it is too expensive." That doesn't cut it. You need a catalyst that you believe will turn that high-flying stock into a stock too expensive for even the hardiest of believers. You need some number, some report, some competitor that could come in and wreck the margins. Without a specific, objective reason to turn the buyers' heads around, you must remember that stocks that go up gain adherents—chartists. They will ride these winners until something fundamental happens to break the overvaluation. If you don't know what that is, don't short. You may not live long enough to collect the gains.

Fourth, please use puts when you can instead of borrowing and selling short stock. Puts don't subject you to the buy-in; they allow you to limit your losses to the value of the put, not to the potentially parabolic run of a stock. Lots of great short sellers went out of business in the 1990s because they shorted common stock, and they discovered that stocks do go to infinity, or close to it, as many of the dot-coms did before collapsing. If you are sure something is going to go down but don't know when, use deep puts going out many, many months. You will never regret paying the extra money. That way you can't be wiped out by an Energizer Bunny like a Research in Motion or eBay or Qualcomm, stocks that hung on longer than anyone thought they would. I can't tell you how many times people got caught in squeezes because they refused to pay the premium for the puts that would have at least limited their losses. You never want a short to put you out of business, but I have seen it happen dozens of times among my own friends. Don't let this be your undoing.

Fifth, never be part of what I call a gang tackle short. If you ever hear of a bunch of people shorting the same names that you are shorting, I can tell you that you are a dead man. Karen would always ask me, "Does anyone else have this call?" If the answer was yes, her answer was always no. She always wanted the information to be homegrown, not borrowed from someone else; created by my own research, not by the research of others. That's because there could be people much bigger than me shorting the stock and then covering to wreck the short when they grew impatient. Too many short sellers means too little stock to borrow means too much of an opportunity for a buy-in to occur.

Sixth, and most important: It is not cool to be short. It is not some­thing to get a kick out of or earn your bones on. Karen sold short for a living. It is gut-wrenching, harrowing, and extremely rewarding when you are right and mind-numbingly painful when you are wrong. There's nothing gallant or suave about shorting. Hedge fund managers always like to brag about their shorts. They think that it distinguishes them as truly intense, sharp thinkers. Nah, my wife would always say. "It's the same as going long, except you can't quantify the loss."

Just in case you don't respect the power of the short squeeze, in case you don't understand how painful these can be, let me leave you with a story that happened to me early in my career and taught me to have a better case and not target takeover stocks as part of my short- selling methodology.

Before I got into the business, I remember being completely mystified by the newspaper phrase "short-covering rally." All buying seemed like "real" buying to me, so what difference did it make whether it was buying to cover a short or not? I couldn't believe that any big stock could be bid up as part of a short squeeze or, more important, a short-term imbalance that an aggressive short seller could create.

One day, after I had been trading alone for a while, I met an analyst who told me he felt that Noxell, now a subsidiary of P&G, but at the time an independent company, could be in for a disappointing quar­ter. As a young hedge fund operator I jumped at the chance to show my shorting colors. Weren't we supposed to be taking bold, contrary stands against companies? Noxell, an expensive NASDAQ stock, seemed ripe for a whacking. After doing my homework I started shorting Noxell gingerly, the same way I would buy a long, shorting a little at first, hoping higher prices would come so I could put out (short) more at better, more ridiculously priced levels. I sold short 10,000 shares at $50 and then said I would short my next tranche of 10,000 every half a point up. The market quickly obliged, and two days later the stock was at $54 and I was short more than 80,000 shares.

When positions would go against me like this, I would frequently go back to the analyst who turned me on to the short and grill him. In this case, the analyst was more convinced than ever that the quarter was weak. I called other analysts around the Street, including those who had a buy on Noxell, and they, too, seemed a bit concerned about how sales and margins were coming through for the cosmetics com­pany. So I put out more stock. I kept to my scale and the stock kept climbing. At $58, now up 8 straight points from where the stock was trading when I started the process, I was short 150,000 shares. When you are running less than $100 million, which I was at that point, you begin to get pretty concerned. I became the Short Noxell Fund.

Over that weekend, of course, I stopped shaving with Noxema Medicated Comfort shaving cream. I had the familiar flush of perspiration of when I had done something wrong every time I looked at the balance sheets and saw that mammoth position. I was panicked, but I stuck with my discipline and shorted more as it kept climbing, even increasing my levels to 20,000 shares every half point because I needed to bring up my basis (the point at which I'd begin to make money). I had to believe that there was no way that profit-takers wouldn't come in to bring the stock down, allowing me to cover some of the shares that I had shorted. I trade around shorts the way I trade around longs, buying some back when a stock gets hit so I can short it again when it rebounds. That way I always feel like I have room to take advantage of the ensuing spikes. But this stock never came down, not a half point even, the whole time I was shorting it.

On Tuesday after the Noxema-free weekend, the stock jumped to $60—up 10 points from my opening short. To heck with the analysts, I said to myself, I started calling anyone, everyone in the business to ask if they had heard anything positive about what the heck was pro­pelling Noxell. "Look, I am short the &%*%a% thing," I would say, "and I just need an explanation for what's wrong." Nobody had one. Everyone was encouraging me to put out more because it was obviously going up for no good reason.

The very next day the stock traded through $63. Now I was asking traders at the big stock houses what was happening, calling all of the honchos who made markets in Noxell asking them what they were hearing. As I was making these desperate calls I saw the stock shoot through $64 to hit $65.

Finally, I broke down and called Karen Backfisch, who would become Karen Cramer, but this was way before I thought that possible. I asked her to find out what the heck was going on with Noxell. I was too embarrassed to tell her that her boyfriend was short the darned thing. But I knew I couldn't figure it out without her. Karen tapped into h,:r network of short sellers who do nothing but talk all the time abo~t who is shorting what and what might be ripe for the taking. These guys knew where every short was buried; they probably even did some of the killing. The news I got chills me to this day and reminds me always how tough being short can be. She said, and I will never forget these words: "Some little joker hedge fund's been shorting the *&& A % / \ & out of it and now the traders are all spreading the word to anybody who will listen that Procter and Gamble is going to bid ninety dollars for the thing. He's got to capitulate and buy it back. They're going to put the little guy out of business, or force him to cover. Get on board!"

Of course little joker hedge fund guy was me.

Oh no, I thought, I am going to be put out of business. I couldn't stand the pain any longer. Not one second. I frantically called a major trading desk and told them I had 250,000 Noxell to buy. With the stock at $64,I would be willing to pay up to $69 for it all. Anything to take away the pain.

One hour later, battling a collective short squeeze of my own making, I took the biggest loss of my career. Noxell 69; Cramer zero. That's right, I paid $69 to bring the whole short position in. I was relieved, I could breathe—heck, I could shave—but the loss was simply unfath­omable.

Crushed. Just crushed.

Not long after I covered, Noxell reported extremely disappointing earnings, much worse than I had expected when I put out the short. The stock plummeted to levels well below where it would be considered a terrific trade, right back to the low 50s. I had been completely and utterly had by a group of traders who fomented what amounted to a nonbuying short squeeze that snared me and only me. Such is the lot of the shorts, though, that this type of incident is all too common. I can't tell you how many times after this that I got the call about some moronic hedge fund that was short a stock that I liked and I was encouraged to walk it up in his face by a trader. Just the way I got hosed in Noxell. And I admit to doing it. The money's just that easy.

Noxell was later acquired by P&G—the rumor had gravitas, but the bid came at a price not much higher than I covered. I simply got beaten by the artificial squeeze.

You would think that the market wouldn't care about one little hedge fund that was correctly shorting a stock. You would think that somehow there would be justice or there would be more of a motivation for a stock to go higher than that a few funds were ganging up on another fund that was short. But that's not how it works. Everyone on Wall Street is out to make a buck any way possible, and if it means trying to put a short seller out of business, then so be it. The dark forces coalesce on both sides of the trade and can force victories and losses regardless of fundamental reality.

What should I have done? Simple. I should have bought deep in the money puts from a far out month that would have allowed me to preserve the trade until the time the company reported earnings. And that's just what I did whenever I shorted after the Noxell annihilation.

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