Wait for the pop before profiting from deflation

EVERYONE has amazing hindsight. To those who go on about the dotcom boom or the credit bubble as being obvious, you should ask how much they made shorting it. The answer is inveterately that they made none.

Today as I write there are several bubbles: China for instance. The idea that China is a bubble is held only on the fringes. To me it’s a bubble that at some time will burst.

The trouble with shorting bubbles is that they can keep on going for a long time. A bubble can inflate way further than you’d guess. So shorting a bubble is very tricky. However, bubbles do not deflate overnight.

DON’T PICK THE TOP
Rather than try and get in at the top, the best thing to do is wait until the fall is well under way then jump on board.

The dotcom bubble took two years to deflate and the credit crunch kicked off in 2007; almost a year before the final crash.

So leaving the bubble to come unstuck is a good idea because although you might lose the bragging rights of catching the top and perhaps a few percentage points, you will lower the risk of the bubble continuing and hurting you.

Also the maths is in your favour. Say the top was 100 and the bottom was going to be 25. If you shorted at 100 and closed at 25, you’d make 75 per cent of your money. If you shorted at 50 and sold at 25 you still make 50 per cent of your money.

For lots of complicated reasons you could argue this doesn’t help, but if you are sure you are dealing with a bubble, it does.

Bubbles very seldom re-inflate, so once a bust is established, it is a one-way bet. Nevertheless, playing bubbles is a tricky business but it is a lucrative one.

LISTEN FOR SILENCE
A good sign a bubble has blown is an initial period of silence, when the market and media seem not to have noticed that the bubble market is falling.

This is a signal that all the longs are in denial. They are of course utterly committed and unable to buy more, so when the rollercoaster comes off the tracks there is often a period of silence, before the screams kick off.

© Extracted from 101 Ways to Pick Stock Market Winners by Clem Chambers (Beautiful Books, £6.99). Clem Chambers is CEO of ADVFN (www.advfn.com), Europe's leading financial market website.