How to Short Stocks
January 24th, 2008 by admin
Selection
1) What goes up MUST come down: the best short candidates are former highflyers of the preceding bull market. Think about it: this alone has just reduced your list to no more than a couple hundred names at the most. Much better than the 10,000 potential candidates you have to sift through on the long side.
2) Cyclicals: the current uptrend which started in 2003 is almost 5 years old. Nobody has outlawed business cycles. Staying with basic materials and capital goods puts a powerful trend on your side.
Many investors/traders who entered the market post 2003 probably believe that the current highflyers can only move in one direction - UP, but that’s what will make the eventual downfall so much more dramatic as investors in the tech/Internet bubble found out the hard way in 2000, and numerous investors in numerous other bubbles before them did too.
3) A clear downtrend: the 50 DMA BELOW the 200 DMA, with both lines declining. The stock must be below both.
Risks
Short squeezes and buyouts are your biggest risks on the short side.
While you can protect yourself against short squeezes by staying with more liquid and established issues with low short interest, there is no real protection against an occasional buyout and a possible sympathy move in the entire group. The best you can do is diversify and trade smaller amounts of multiple stocks in the same group to minimize damage.
Timing
Long-term trends do not reverse in a day.
On its way up a stock changes owners several times. The latecomers who buy at the top do not give up easily: they are armed with the stock’s long history of stellar earnings and spectacular rise. The stock has broad institutional sponsorship with firepower to support the price. There are bargain hunters down below waiting to buy at a discount.
But the shrewd operators and insiders already know the party is over. They are the ones quietly distributing to the unsuspecting public. Sharp shorts sense the change in mood and start selling. But bouts of selling are followed by heavy buying from the above groups and short squeezes, causing the stock to spike back.
Longer term, history and the law of physics are on the short side. As they say on Wall Street, stocks are put up but fall under their own weight. Longs are literally fighting an uphill battle. One by one, they give up. Bargain hunters run out of cash from doubling down. They now operate on hope. They are hurting, and as the pain becomes unbearable, they sell in disgust. Institutions rotate out. The spikes lose intensity while failing to regain the old highs. The stock gets exhausted and finally breaks through long-term support. THIS IS YOUR BEST PLACE TO SHORT.
ATI as an example
It peaked in late April 2007. It failed to build a proper base, printing a series of lower highs (June 1, July 19) and lower lows, finally slicing through the 200 DMA on August 10. But the 50 DMA was still above the 200 DMA, and the 200 DMA was rising. The 50 DMA crossed the 200 DMA in early September 2007 but ATI bounced back from a double bottom as the general market improved. ATI spiked back above the DMAs, peaking on October 9, making a third lower high in a row.
The gap down on October 12 presented a good shorting opportunity. But the longs still had firepower left. Two more lower highs (October 29, November 30). Notice how the intensity of those spikes decreased, even though they became more frequent. Each time the stock found support around $90.00.
Now, a fundamental difference between buying breakouts and shorting breakdowns is that with the exception of huge gap downs caused by overnight news, capitulations are often anti-climactic. The stock wears down gradually. The slide starts slowly then accelerates.
The right time to short ATI was when it broke through $90.00. But it did so multiple times in December before finally moving lower, and still had one more pullback. And that’s another major difference: instead of a clear pivot you had a window of opportunity.
Now that the long-term support has been taken out, it is safer to add on pullbacks to the DMAs. And, as always, it’s important to keep an eye on the market as stocks do not trade in vacuum.
Slav Fedorov is a full time stock trader and founder and managing member of TradingZoom, LLC - a provider of proprietary trading data that swing traders can put to work right away. http://www.tradingzoom.com
Posted in Online-Stock-Trading, Selling-Stock |