Don't lose your shorts!
Thursday, October 18, 2007 | Ethan Roberts Is this Spam?I was inspired to write a member's article after reading Jason's article the other day on shorting, as well as some of the member comments.
I myself like to short stocks. When you short a stock, you are predicting that it will go down, rather than up. The main reason that I like to short stocks is that they tend to go down much quicker than they go up, so if your selections and timing are right, you can really prosper.
As Jason wrote, it is technically true that a stock can go to infinity. Therefore the risk of shorting is greater than long positions. However, in reality this rarely happens. Even if the stock goes up after you short it, most stocks will pull back after a lengthy increase, giving you a chance to get out. This is because:
1) People with winning positions begin to sell their shares, so as to lock in profits.
2) Other people begin to short the stock
3) Enthusiasm over recent positive news on the stock, which sent the stock higher, tends to wane as time goes on.
My strategy is to use technical indicators, such as Relative Strength Index (RSI), stochastics, and Moving Average Convergence Divergence (MACD) to tell me when a stock is extremely overbought on either a daily or weekly basis.
Although a stock can remain in "overbought territory" for quite awhile, and keep going higher, the best time to set up the short position is when the indicators begin to turn down from the overbought level. That shows you that the buying strength is beginning to weaken.
There are so many different technical indicators, that it is not possible to discuss them all in one article. But just to take one for example, RSI readings above 70 would indicate an overbought condition, while a reading below 30 would be oversold. For information on what constitutes overbought and oversold levels for the many indicators, I would refer you to any of the good books on technical analysis, such as John Murphy's "Technical Analysis of the Futures Market". There are also web sites that cover this information.
I frequently check the list of stocks which are the largest percentage gainers for the day in order to find possible short candidates in the near future. It is common to see a stock make a large percentage move on two consecutive days, but usually by the third day, the move is exhausted.
At that point, especially if the recent percentage gain is 20% or more, the stock becomes an excellent short possibility. One tip off to the weakening demand is when you see decreased volume on the last up day.
Many stocks will retrace one third to one half of the gain they make from a base. That is enough to provide a very nice short term (one day to several days) gain on the short position.
Now, as for caveats. As Jason mentioned, it is both possible and advisable to put in a stop limit order above your short price to cover your short position. This will protect you from taking a big loss if you are wrong.
Immediately after I short a stock, I put in a stop limit order about 10 cents above the stock's most recent high price (not my shorted price). In that way, if I am wrong, and the stock is going higher, I can get out with just a small loss. A stock will often re-test its recent high, so by placing the limit order 10 cents above the recent high, I protect myself from being "stopped out" prematurely by a stock that fails to surpass the resistance of its recent high. As bad as it is to take a small loss, I think it hurts even more to get stopped out, only to see the stock reverse and drop lower, wiping out a big gain you could have realized.
Be aware that if you don't put in a stop limit order, shorting these type of stocks becomes a high risk trade. There is a good reason that these stocks have advanced so quickly, and once in awhile, no matter how overbought they seem, they forget to stop rising!
A different approach to shorting is to buy an ETF that shorts a market index. I like to buy the Pro shares ultra short QQQ (QID) when the market is extremely overbought, as it was a few months ago. The QID shorts the Nasdaq 100, and the return is about twice the opposite return of the Nasdaq. That is to say, if the Nasdaq is down 1%, the QID will rise about 2% and vice versa. It even pays a nice fat dividend!
Other ETF's that short the market are the ProShares Ultra Short S&P 500 (SDS) and the ProShares Ultra Short Dow 30 (DXD). These ETF's are all quite volatile, so protect yourself from large losses with downside stop limit orders.
During the last market correction, the QID helped me to offset some losses that I had in my long term buy positions. Just make sure you sell the ETF's and take your profits when you believe the correction to be over! You want to be out of these shorting ETF's when the market rebounds, as it recently did.
Shorting can also be utilized with stocks on a bad news story (such as today's, "SEC questions Countrywide CEO stock sale), or with weak earnings reports, analyst downgrades, etc. However, just as one should not buy stocks that are overly extended, one should not short stocks that are overly extended to the downside. Although the longer term trend may be down, you can be stopped out of your short position quickly by any near term bounce by an overextended stock.
Remember, shorting can be fun and profitable, and if you cover your shorts, you will never lose them!
