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 (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.

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