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Options - Identifying Bearish Stocks

Jun 30, 2008
The big question I am often asked is, "how do I find stocks that will keep falling in value". Well, it is actually much more difficult to identify stocks that will continue to fall in price as compared to finding stocks that will appreciate in value. This is why I recommend bearish plays only to more experienced investors who have mastered the art of buying bullish stocks first.

The most common reason for a stock to decline is because of bad news that causes investors to lose faith in the company's ability to continue increasing earnings at the projected rate.

The most common reasons that cause a stock to fall are:

1. The company reports earnings (on a quarterly basis) that are below analyst's forecast

2. The company loses its competitive advantage (e.g. A drug company loses its patent on a best selling drug)

3. The company is being investigated for accounting irregularities

4. Analysts downgrade the stock as a result of any of the above reasons

5. The economy is in a recession and the whole stock market is in a downtrend, pulling every stock down with it

Avoid Shorting Stocks When the Bad News Seems Temporary

Usually, when the bad news hits a company's short-term profitability but DOES NOT affect its competitive advantage to grow earnings in the future, its stock price will usually turn around after the initial decline.

Most companies who report lower than expected quarterly earnings usually fall into this category. There are many factors that could cause a company's profits to drop temporarily. They are rising material cost, failed products, poor acquisitions and a temporary drop in demand. These are stocks that you would NOT want to buy Put Options on.

When the Bad News is Permanent, Go for the Kill!

I usually buy Puts on stocks which I am very confident will continue to decline for a couple of weeks or even months! These are stocks hit by bad news that causes long-term or permanent damage to its profitability of financial stability.

The best bets are when a company is being investigated for accounting fraud. This process usually drags on for months or even years and the fear & uncertainty about the extent of the damage keeps buyers away and allows sellers to push the stock even further down. In such scandals, there is also a big possibility that even more bad news will be uncovered. As more dirt is dug up, it will usually send the stock price spiralling downwards.

For example, when AIG was first investigated for accounting irregularities, it was believed that it inflated its earnings artificially by about $1 billion. As investigations went on, the figure got larger and larger. These sequence of events caused AIG stock to continue its decline from $78 to $51.

What makes the stock decline even stronger is when a company is being pounced on and regularly attacked by the media. For example, when Tyco's CEO was first being investigated for stealing millions of dollars, the media kept playing up the bad news almost every hour on CNN and CNBC. This bad publicity caused even more panic and sent the stock to spiral down even faster!

One reason why I love betting on such falling stocks is because stock prices tend to fall a lot faster (from bad news) than they rise (from good news). As a result, you earn your profits much faster!
About the Author
Adam Khoo is an entrepreneur, best-selling author and a self-made millionaire by the age of 26. Discover his millionaire investing secrets and claim your FREE bonus chapter of his latest bestselling book 'Secrets Of Millionaire Investors' at Secrets Of Millionaire Investors.
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