In my last post I wrote that the most important thing to consider before you decide to short stocks is evaluate how the overall market is behaving. Once you determine the market is conducive to shorting stocks how do you determine what stocks to short?

In general you should look for stocks that are trading at high valuations but that don’t have the financial numbers to justify the lofty valuations. A good example of this is the run Jones Soda (JSDA) had in 2006 and 2007. The stock price of Jones Soda went from around ten dollars to over thirty dollars in about five months but the financial numbers of Jones Soda did not show any significant improvement. It was inevitable that that stock price was going to crash. To make matters worse for Jones Soda the company’s financial numbers started to deteriorate and the company is now trading at under three dollars.

My example of Jones Soda provides another thing to look for: rapidly deteriorating financials. Stocks that have rapidly declining earnings and revenues are good places to look for short opportunities regardless of valuation. At the beginning of 2007 most banks, bond insurers, home builders, etc. were trading at reasonable valuations. However, if you foresaw the havoc that the housing bubble collapse was going to cause you could have made a ton of money shorting these companies.

Stocks that have huge speculative run-ups are another place to look for short opportunities. However, stocks that make huge short term jumps usually take a while before they correct back to there previous support level. Therefore, you have to have patience.

As an example take a look at the 2 year chart of Copernic (CNIC), formerly Mamma.com (MAMA). In December of 2006 the stock price of Copernic jumped from around two dollars to over eight dollars in a week. The cause of this was a press release stating the company was going to offer video search. I knew this was not going to improve the financial numbers of the company and I recommended shorting the company. I made a profitable call but I lost patience and I recommended covering CNIC too soon. However, it took eight months before the stock price declined enough to erase the underserved gains the company made in one week. Some more examples of companies taking a while to correct are SWC and COIN.

Also, if you are going to short a stock that has a huge short term run-up make sure you understand why the company jumped up so much. If you don’t know why the company made such a significant increase you should avoid shorting the company because the jump might be justified and the company may continue to go up. However, companies that make huge jumps based on sheer speculation provide good shorting opportunities.

Finally, you should take into account that even though some stocks make huge irrational gains doesn’t mean that won’t keep going up. Investors (gamblers) may continue to completely ignore fundamentals and bid these companies up. For example take a look at micro cap oil companies MXC, ROYL, and FPP. All of these companies have made ridiculous undeserved speculative gains but they may continue go up if oil futures continue to press on. All of these companies will probably see significant declines at some point but shorting these stocks would be risky. Remember, “the market can stay irrational longer that you can stay solvent” (John Maynard Keynes).