Most investors think a good business idea equates to a solid long term investment. While this is true on balance to some degree, many people don't understand that stocks trade in a market and like all markets things are marked up and go on sale for many different reasons, not all of them rational or honest. Indeed, in many markets items are overpriced or sold below wholesale cost because of supply and demand factors. The stock market, despite what efficient market theorists believe, is no different at all. If a certain large trader for a bank or hedge fund wants to mark the tape and "make" a stock he is long or short move in a desired direction the trader can simply push the stock where he wants it to trade. If you are in cohorts with other major players in the market, this type of market manipulation is as easy as third grade math. When ABN and Fidelity decide that XYZ should trade for X one of the institutions simply places the bid out there and the other institution can move in behind the bid with more buy orders to "beef up" the tape even if that institution doesn't really want the stock in question. While this type of "bad boy" trading is technically illegal, it happens all the time and in just about every equity imaginable. What astute traders have to learn is how to decode a "promotion" or a "pool" in order to find out when the party ends and the stock in question is going to blow up.
With web 2.0 names, the key is to stick with the smaller players and trade from the short side. Wait until the issue becomes extremely overbought on all chart time periods from the 5 day to the one month to the one year and short small amounts with tight stop losses. When a bubble finally pops, you have to be in it to win it from a short selling perspective and a bunch of tiny losses can be made back and profits reaped by holding short with tight stop orders in place.
Another technique is played out using options. Many shorts find an overvalued and over-hyped pump to short but constantly get stopped out right before a massive crash. The traders in these think that nothing can be done to short such momo darlings and give up with losses because they either lack the time or discipline it takes to trade with the trend in the stock. Waiting for the right entry point is key, but another strategy is to buy call options in the same notional amount as the shares you are shorting. For example, you may think Salesforce.com (NYSE:CRM) is going to blow up so you short 1,000 shares and buy 10 slightly out of the money or in the money three month out call options on CRM as a hedge. If the stock moves higher, you can sleep easy knowing that the call protects your risk and that your max loss on such a position is around 5-7% depending on your strike price.
Here are a few stocks that may make decent short positions if the summer doldrums return or "sell in May and go away" returns to the stock market.
Pandora (NYSE:P) is a fantastic business, but the stock is pretty expensive and the momentum has all but left the building as far as the tape is concerned. Investors who are long P should sell calls against their position to lower their overall cost basis. If you are bearish on the overall stock market, selling a bear call spread on Pandora makes sense. One way to short P synthetically using a bear call spread would be to sell the $8 calls and buy the $12.50 calls on the stock as a hedge. Additionally, bearish traders could buy an $8 call option on P and short the stock in the same amount. Pandora's revenues and traffic are in super-growth mode but the stock price may already reflect a very rosy outcome for the company.
YELP.com (NYSE:YELP) -- claims to be the yellow pages of the internet, but the only problem is that Google (NASDAQ:GOOG) is doing a good job with Android phones to make all of these type of services obsolete. With Google smart phones you can simply Google the name of a business and get reviews and a phone number in seconds and if you click on the number you can call the business instantly without even having to dial the phone number. I don't know what is more convenient than that and I fear that Yelp is swimming in the shark-tank from a competitive advantage point of view. Hopefully, I am wrong because I like smaller web companies a lot and I think Yelp is a great service. In the end, however, a great service or great product does not guarantees investment success. Just ask all of the Green Mountain Coffee Roasters (NASDAQ:GMCR) investors who bought that stock at $110 a share. Look, the coffee tastes just as good now as it did then, but the stock has lost some 50% of its value because it was overpriced and is now priced more rationally by the marketplace.
Angie's List (NASDAQ:ANGI) -- I finally entered into a sizable (for me) short call position on Angie's List because the valuation doesn't make sense to me. The web 1.0 companies like TheStreet.com have as much web traffic as Angie does yet their valuations are some 1/12 of ANGI. To me, this suggests that ANGI is a bubble even though the web site is growing and extremely useful. In other words, with ANGI investors are paying $870MM for what I believe to be a $200MM company at best.
Saleforce.com -- Another revolutionary business model that doesn't make sense as a public security at this price is Saleforce.com. More specifically, CRM stock -- the company is trading for a mind blowing price to earnings, book value, and cash flow multiple yet the business is growing at a 38% top line growth clip. Unless revenue growth translates into bottom line profit fairly soon, I expect CRM stock to return back to Earth at some point in the not too distant future. Selling a May $160 call option and buying a May $170 call option as a hedge makes sense to me.