Mad Money

Cramer's 6 vital rules to short selling

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Jim Cramer thinks this market is about to change. In the future, the Fed will be raising interest rates, and that means investors must be more careful allocating capital.

"We recognize that the stocks bought for yield will be sold and that bonds with low coupons—low interest bearing paper—could be dangerous," the "Mad Money" host said.

With this in mind, many investors will want to create short positions against the market. And while Cramer is not allowed to create short positions in his Charitable trust, he did short almost every day when he worked with Karen Cramer at his hedge fund. In fact, Karen Cramer hated long positions and loved the short side.

And Cramerica is just in luck, because Karen Cramer shared her short-selling rules with Cramer. Rules that are timeless and can still be applied today.

Rule No. 1: Called the Business Week cover rule. At the time, this publication often featured companies on the cover and their stocks would often jump following the issue's release. Thus the rule to never short a company that could be on the cover of a big publication was born.

"I have augmented this rule and it's very simple: never short a best-of-breed company. There are so many crummy, awful companies out there, why bother to short a company that is a standout that could be considered among the best of the best just because you are hearing a negative story? Move on," Jim Cramer said. (Tweet This)

Rule No. 2: Ask yourself, can the company be taken over? If it can, then don't short it. Cramer was burned on this rule three times in his career, and when he looked back he remembered that there were takeover rumors about all of them. He ended up taking a loss on all three companies. (Tweet This)

Rule No. 3: Never short a stock because it seems like it's overvalued. Cramer advised never to try to call an irrational top based on multiples of sales, or earnings. Why? Because there will always be a mutual fund out there that will crush you.

For instance, Chipotle seemed expensive at one time and then grew its market cap substantially. Some biotechs can even seem like they have no earnings, but then get a bid anyways. It doesn't matter if you think something is too expensive—don't short it.

Rule No. 4: Never use a common stock to short if puts are available. In the case where Cramer lost money on the three takeover bids, puts would have stopped him from the hideous losses. The important thing to remember about puts, are that it will stop you from being bought in. This means that a brokerage house cannot come back and demand the stock to close out your short position without your consent. (Tweet This)

Thus, if you are sure that a stock is about to go down but aren't sure when it will happen, then Cramer advised to use deep-in-the-money puts that go far in time. It will always be worth it.

Rule No. 5: Never be part of a gang tackle. If you hear a bunch of investors that are all shorting the same stocks you are shorting, that is bad news. They will abandon their shorts if things get tough and drive the price higher. There is too much risk of what can go wrong if you short a stock that everyone else is.

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Rule No. 6: If you don't like the market right now and you think it is going to go down, then just raise cash. Trim your stocks, rate them and decide which ones you don't want to keep and get rid of them. When the Fed was lowering rates, then you didn't want to keep cash. Now that rates are going to go higher, cash is king.

"I know you might be itching to short. I am just begging you to realize that there is substantially more downside and you must be much more disciplined if you are going to pull it off right," the "Mad Money" host added.

In that case, it might be a better idea to raise cash and be ready to use it in the next Fed-related downturn.

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