This chapter covers:
Why you must learn to sell stocks short
What it means to short a stock
Differences between shorting and regular (long) buying and selling
Importance of setting stops
Mechanics of shorting
How to pick good shorts and avoid bad ones
Psychological barriers to shorting
Exercise in picking short plays
TRADER TALK Taking a stock long means buying a stock with the expectation that its price will go up.
Selling a stock short means selling a borrowed stock with the expectation that its price will go down.
Mama said there would be days like this. Boy, was she right.
All of a sudden the market abandons the good times like last week’s fishhead stew and starts screaming downward, straight toward the bowels of hell. It just goes down, down, down like there’s never been another way to go. You realize that we’re having a major, big-time, grab-the-lifeboats correction.
Every stock on the board is down 15 percent, 20 percent, 30 percent—even more. Even the ones everybody respects. The NASDAQ is down many percentage points for the day—maybe 5 percent, maybe twice that much.
When a bloodbath happens, it happens fast and ugly.
Why is this happening? you ask. Maybe the market has soared for weeks, to the point where no one believes the stocks’ valuations make any sense. When the market is thoroughly bloated and stock prices are puffed up like thousands of piping hot soufflés, just about any news that’s less than stellar will send institutions and investors fleeing for the exits. Or maybe an international financial crisis suddenly threatens to derail the economy, creating the specter of global recession and all kinds of worldwide gloom and doom. Or maybe Alan Greenspan just scratched his nose three times today instead of two.
Whatever the reason, chances are that this eye-popping crash was not the first sign of trouble. Like the sky before a bad thunderstorm, the market may have been clouding up for weeks. There may be more talk of overvaluation. Analysts may all be saying that a correction is needed to get prices back to reasonable levels. The market may have adopted a recent pattern of going down more than up. Those who kept an eye on the darkening heavens may have quietly started bringing their toys in from the yard in case of rain—selling most of their stocks and assuming a largely cash position to protect their capital.
You may be one of the sellers. Maybe you started to unload your stocks when you saw that the market had run up so fast and become so inflated that you knew it couldn’t last much longer. More likely, though, you’ve taken a hit. No one can guess exactly when the market will correct, and it doesn’t really make sense to try, though there are trends that can give you great clues. But even if you’ve taken a hit, it won’t be a huge loss, since you’re a responsible trader who always sets stops to protect yourself against just such a conflagration. You’ve now stopped out of all your positions. At least, let’s hope you did!
The most important thing, always, is to survive to trade another day. Your capital is your lifeblood. If it’s lost, the patient is dead.
At this point, the good news is that you’re not going down in flames with the rest of the market. The bad news, though, is that the market just keeps falling like the rain in Spain, and you’re starting to freak because you see it’s impossible to make any ka-chingos by buying stocks. The analysts on TV keep telling everyone to “buy the dip,” but they have no clue what kind of dip this is—is it a true market bottom, or just the middle of a long downhill slide? Every time you buy, your stocks tank along with the rest of the market and you stop out, again and again. Those small losses are adding up, and it’s really frustrating. This bad market weather can go on for days at a time, with short one-day relief rallies that are just convincing enough to fool you into letting down your guard and buying just as the rally evaporates. That will be the dominant pattern when the market is trending downward. A real correction can last for weeks, even months. A bear market can last much longer—even years (the average bear market lasts about eighteen months).
So the question is, what do you do? How can you make good money in a sinking market?
There’s only one thing to do when the market tanks, and that’s to sell stocks short.
When the market’s in the middle of a spirit-crushing trip to lower ground, you cannot buck the trend and try to buy stocks. In a correction, even the strongest, highest-quality stocks will eventually begin to lose value. The party train has gone into reverse, and it’s picking up speed. You can’t stop it, and if you try, you’ll be crushed beneath its wheels. Instead, you have to climb aboard and ride!
And how do you ride the train on its journey back down the hill? To ride a stock downward and profit from the trip, you have to sell it short.
RULES OF THE GAME Be flexible. Don’t fight the market!
So, exactly what is short selling?
Selling a stock short means that you sell it without first owning it. You do this when you expect the stock’s price to go down. Here’s how it works: By selling short, you’re borrowing the stock from your broker and selling it when you think the price is as high as it’s going to be for a while. When the price goes down, you close the position by buying shares—to replace the ones you borrowed and sold—at a lower price than you sold them for. Borrow shares and sell them high; buy them back lower and return them. Ka-chingo!
Here’s another way to look at it. Instead of buying low and then selling high, you just do the same thing in reverse order: Sell high, and then buy low. Same price difference, just in reverse order because the price is moving down instead of up.
Here’s an example: Let’s say you think the stock of Dot-com Goldrush Corp. (symbol WEAK) is going to head down. The price is $35. You sell 100 shares short at $35 and wait. The next day you’re ecstatic when WEAK takes a dive on an analyst’s downgrade and slides to $27. Die, WEAK! At this point you’re not sure it will go down anymore, so you buy the 100 shares back at $27 to close the trade. Your bargain-basement purchase of WEAK has given you the difference between a $27 purchase and a $35 sale—eight dollars per share, for a total return of $800.
Kill the stocks! Kill the stocks! Die, die, die!
There aren’t too many differences between shorting and buying long, but there are a few important ones.
1. Margin status.
A short sale is a margin transaction. This is because you have to borrow shares from your broker to sell short, and borrowing means you have to be approved for margin. If you don’t have a margin account, you can’t sell short.
2. Price limits.
Your broker may allow you to short only stocks above a certain price—for example, only stocks costing five dollars or more per share. And you can short only the stocks that your broker considers “marginable.” You also can’t short initial public offerings (IPOs) until thirty days after they’ve started trading.
3. Share availability.
There will be times when your broker has no shares of a particular stock available for you to borrow. When this happens, you’re just plain out of luck.
4. The “uptick rule.”
The uptick rule is a Securities Exchange Commission rule that allows short selling only where the most recent bid on the stock is an “uptick,” meaning that it is higher than the bid that came just before it.
For example, let’s say the bid on FiscalChaos.com (DEBT) is at 12.63. If the bid appears on the screen in green or is shown next to an uptick symbol (a plus sign or up arrow), it represents an increase in share value over the previous bid—an uptick. For example, if the previous bid was 12.50, then the bid of 12.63 would be an uptick. With such an uptick, you can short DEBT at 12.63.
If the bid of 12.63 appears in red or is shown next to a downtick symbol (a minus sign or down arrow), though, you cannot short it at 12.63. (A downtick, as you’ve probably figured out, is a bid that’s lower than the previous bid. Here, the bid may have gone from 12.75 to 12.63.) In this situation you can try to short DEBT at 12.64, because if the bid goes from 12.63 to 12.64 it will create an uptick.
The bottom line is that you have to wait for an uptick in order to sell short. As soon as the bid rises by any amount, it’s an uptick and the stock is shortable for as long as that bid or any bid following it remains an uptick. Another way to state the rule is that you can’t short on a downtick.
5. Terminology.
When you sell short, you don’t “sell” a stock and then “buy” it back. Instead, you first sell the stock short and then buy to cover. These are the types of orders you must place to open and close a short position.
6. Reward.
When you buy a stock long and it goes up in price, it can—at least in theory—keep going up forever. No stock on planet Earth will really go up forever, but a good stock can go up 200 percent, 500 percent, or even more—sometimes in a short time, sometimes over a period of years.
When you short a stock, though, the situation is a bit different. If you think about it, the best possible outcome when you hold a short position is for the stock to go to zero. Most stocks won’t go to zero, but they can lose half their value or even three-fourths of it. If a stock loses half its value, your return is 50 percent. If it loses three-fourths of its value, your return is 75 percent. If it actually goes to zero (because the company goes out of business entirely, let’s say), your return is 100 percent. But your return on a short can never be more than 100 percent.
(Another limitation to the return on a short is that, since every short sale is a margin transaction, you can’t increase the size of your positions by borrowing additional shares on margin because you’ve already borrowed shares on margin. When you go long, you can borrow against the shares and, at least theoretically, double your return or better. When you sell short, you hold nothing to borrow against because the shares are already borrowed. This means you can never sell short an amount of stock whose value exceeds the value of your account.)
On the other hand, stocks tend to fall faster than they rise, so you may get your return on a short sooner.
So there’s a limit to the return you can make on a short, while there’s theoretically no limit on the return you can make going long. Realistically, though, a 10 percent to 30 percent return is a pretty good ka-chingo for any trade, long or short. It’s entirely possible to make that kind of profit with a good short, and it’s the same return you’ll make on the majority of long plays, anyway. And the beauty of being a trader is that you’ll limit your loss either way by using stops.
7. Risk.
The most important difference between buying long and selling short is the magnitude of risk involved. This is the flip side of the difference in reward discussed above. When you buy a stock long, the most you can possibly lose is 100 percent of your money. With a short, though, the theoretical possibility of loss is infinite. In other words, in theory (but not in practice), there is no limit to what a bad short can cost you.
For example, let’s say you’re convinced that the price of Lame-ways, Inc. is going to go down. You have your reasons, and they’re sound, and the time is right. So you short 500 shares of LAME at $10 per share—a $5000 investment—and sit back to wait for the big crash. The price goes down some, and you’re comfortably cheering it on to its shameful demise. Die, you dog!
Well—wouldn’t you know—the very next afternoon LAME announces that it’s just signed a contract to be the primary supplier of turbo-cyberwidgets to the world’s biggest purchaser of the freaking things—a contract worth $100 million a year for the next three years. For LAME, this is the contract of a lifetime. The stock goes to $15 that day, and the next day hits $20.
If, for some inexplicable reason, you did not set stops, what does this mean for you? You guessed it—Disasterville. If you bought the stock at $10 and it’s now $20, your loss is equal to exactly the amount of your investment. This is because, if you shorted 500 LAME at $10, you borrowed $5000 worth of stock. (This is what you “paid” for your investment, in effect, because it’s the amount you put into the trade.) If you have to buy it back at $20, the cost will be $10,000: a $5000 loss. You have to replace the borrowed stock at whatever price it takes to get hold of the shares. If you replace the shares at $20, you have lost your entire investment.
Suppose, though, that you decide to wait to cover, hoping (yikes!) that the price will go down. Unfortunately, the stock continues to climb. Let’s say it hits $30. Now you’ve lost twice as much as you invested in the first place. If the stock continues up to $40, you lose three times your investment. And so it goes, in theory, up to infinity.
Now, before you swear that you’ll never be moronic enough to sell a stock short and take on infinite risk, there’s one important thing to consider: If you set stops on a short, the risk is no different than it is for a long position. Any time you short, you must follow the same rule you follow on every play: You must set stops! If your stops are in place, you’ll automatically limit your loss and avoid Disasterville.
Some people like to point out that no stock really goes to infinity, and that even if it did, it would probably take more than a day or two to get there. That’s true. At the same time, a bad short doesn’t need to go to anywhere near infinity to leave your account as empty as a nuclear winter, and some stocks do climb like overachieving mountain goats. If you let a bad short get completely out of control, this is what will happen: Your broker will give you a margin call before you can owe too much more than your account’s value, you’ll cover the short at a huge and painful loss, and, as for your account, it’ll be all over but the shouting. The point is that there’s never a good reason to take chances. I’ll repeat it until you hear it in your own head: You must always set stops.
WAXIE’S STREET SMARTS
Assuming that you’re setting stops religiously, as you must, the only way you can really get into trouble with a short is if the stock price gaps up tremendously overnight in response to some news and you don’t have access to premarket trading. A stock’s price can change rapidly in the half hour before the market opens, and there’s not much you can do if you can’t trade during that half hour. For this reason, you should never hold a short that has spent its downward momentum and stabilized at some level. You have little to gain and are risking a sudden change in the company’s situation that could make you wish you’d closed the position with a profit.
If you’ve never shorted before, please go slowly. You should try a few short sales in a simulated online portfolio or on paper before you jump in with real money. The more comfortable you are with the entire process, the clearer your thinking will be.
The mechanics of a short sale are the same as a normal sale, except that you must sell on an uptick and use the appropriate type of order.
Step 1: Sell short using a limit order.
Always, always use a limit order when selling short. A limit “sell short” order will guarantee that you will not sell short for less than the price you indicate. By contrast, using market orders to sell short is extremely hazardous because of the uptick rule. If you use a market sell short order and the stock’s price starts to fall quickly, there can be a long series of consecutive downticks that will prevent your order from being filled. If the price has fallen significantly before an uptick occurs, you will end up shorting the stock at a much lower price than you wanted to, and probably near its low point—just as it’s getting ready to bounce back up.
For example, let’s say you try to short Pigdog, Inc. (DAWG) with a market order at 45.63. The stock is on a downtick, and then it begins to fall quickly. The bid keeps going lower and lower (downtick after downtick, with no uptick) until the stock finally bounces (an uptick) at 36.5. Your order executes at 36.5. DAWG is now 20 percent lower than the price where you wanted to short it. Not only is most or all of your potential gain gone, but you are in danger of shorting at exactly the point where the slide stops and the stock begins to bounce back up.
Using a limit order to short DAWG works this way. Let’s say you set your limit order at 45.63. If there is an uptick on the bid at 45.63, your order will execute at 45.63 because your limit order allows you to sell at 45.63 or higher. If the bid of 45.63 is a downtick, then the order will fill only if the bid moves up to 45.64, or if the bid drops below 45.63 and later moves back up to 45.63 on an uptick.
Step 2: Set a stop immediately.
Once your short sale order has filled, you should immediately place a stop buy-to-cover order. This is your protection from a sudden rise in price that could cause a huge loss.
Step 3: Close the short position by buying to cover.
When it’s time to close the short position, you simply place a buy-to-cover order—you should normally use limit orders here, as well—for the same number of shares you sold short. (An exception is if the company completed a stock split while you held the short position; in that case, you must buy the number of shares you held short after the split. For example, if you shorted 200 DAWG on March 1, the stock split two for one on May 1, and you wanted to cover on June 1, you’d need to cover by buying 400 DAWG. This situation is discussed further at the end of this chapter.)
Some brokerages won’t let you use regular “buy” order to cover a short. If this is your broker’s rule and you do use a buy order, you’ll end up with both a short position and a long position. Their gains and losses will cancel each other out, but you’ll tie up lots of money for no reason.
A buy-to-cover order is not subject to any sort of uptick rule or other complication. In terms of mechanics, it’s just like buying any stock. Only the type of order is different.
You see, it’s not so hard! Try a few short sales in a simulated trading account or on paper, and then try a small one in your real account. When I tried my first short, I made it a small one. I looked at it as a new experience—like trying cotton candy for the first time, or Indian food, or skinny-dipping! Yeah, baby! As always, sell a stock short only if you believe it’s a winning trade. Always have a plan, and always set a stop.
As with taking a stock long, the two aspects of shorting that will contribute most to your success are having a good reason for the play and entering at the right price.
A stock might be a good shorting candidate for any of a number of reasons. The more of these reasons you see in a play, the better your chances of success. In other words, three sound reasons are better than one, and four are better still.
In general, one of the best times to short is when the market is really tanking. On a day when the NASDAQ is in the negative by over 150 points, chances are good that any stock still showing a gain for the day will eventually succumb to selling pressure—unless it has risen for an unusually compelling, company-specific reason.
On the other hand, a raging-bull rally is generally not a good climate for shorting, no matter how weak the stock, unless—again—there’s a company-specific reason. Remember, you can’t fight the market. And “choppy” days, when the market can’t make up its mind on direction but instead swings back and forth between positive and negative territory, aren’t great days to trade at all—long or short—because it’s so easy to be whipsawed by quick reversals and lose money no matter what you try to do.
It’s often a good idea to short on days when the market is in a stinky, bearish mood, or even a full-blown correction. Even on brutally negative days, though, keep in mind that the market can reverse direction very, very quickly, and often when you least expect it. Always use stops on your shorts to guard against disastrous bullish surprises. And you can short selectively even on rally days, since stocks will be running up on news—allowing you to “sell the news.”
Aside from general market conditions, the things to look for in a potential short play are generally company-specific, or at least sector-specific.
When bears rule the market, the best stocks to short are those that have run up a lot—say, 40 percent or more in a day—on fairly trivial news. These stocks tend to drop back very quickly when day traders sell, seeing no more upside potential, and other short sellers move in. Here’s an example: Me-Too Fiber Optic, Inc., a company with serious financial troubles, announces that it has received a small order from a large customer. This is not exactly earth-shattering news. Amazingly, though, the stock price is up 50 percent for the day. Especially on a negative market day, this is a very good short. As always, use a stop buy-to-cover order—if the price goes up more and you stop out, you can always reshort at a higher price.
In any market, bullish or bearish, a great time to short a stock is right when it reports earnings, unless the earnings are truly eye-popping or the stock is extremely popular. The dominant trend is for stocks to rise into earnings and fall after earnings are announced. (This is a classic example of “buy the rumor, sell the news.”) The same is often true for stock splits: the price usually rises as the split date approaches, but within a day or two after the stock starts trading at its split-adjusted price, the price starts to fall. And in a bull market, a really great kind of stock to short is a parent company that has just spun off part of itself as an IPO. The parent’s stock rises into the IPO, then tanks—often within minutes of the time the new issue starts to trade.
WAXIE’S STREET SMARTS
Good reasons to short:
Rapidly falling market
Clear break below support
Stock has run up too far, too fast
Rumor’s been bought; it’s time to sell news
After rise into earnings
After rise into split
After IPO lockup expiration
The chart below shows the behavior of a stock that has broken below support.
Bad reasons for a short
In a bull market, there are quite a few bad reasons to short a stock. Here are some examples:
1. The company has a bad business plan and must eventually fail.
2. The stock has been “acting weak.”
Yahoo! Inc. (NM), Daily – QCharts ©2001 Quote.com
Break below support.
Copyright © 2001 Quote.com, Inc., a Lycos Network site. QCharts is a registered trademark of Lycos Network. All charts or trading products or services mentioned herein are those of Lycos or their respective owners. All rights reserved.
4. The stock price has gone up so much that it has to go down.
What’s wrong with shorting an overvalued stock? Isn’t it common sense to short an issue that’s overvalued, since the market must eventually bring the price down to where it belongs?
Some of the best advice I can give you is this: In the stock market, beware of common sense! When the bulls are running, common sense can be your worst enemy. Rational valuations and logic are not keys to success in an exuberant market. If anything, they’ll lead you to disaster. A popular stock whose price is higher than you think it should be can keep rising in price for a year, and can easily quadruple in value before it comes back down. You can’t fight the market, and you shouldn’t try. The market is not efficient, and it doesn’t necessarily reflect the true value of anything at any particular moment. Instead of thinking about what stocks’ valuations should be, you have to be willing to accept what the market offers and play by its rules—by using market trends.
Misplaced loyalty
In some cases, the skills that serve you well in trading will also serve you well in life. For example, discipline, both in trading and in life, is incredibly important if you want to succeed. So is having a plan. If you don’t have a plan in life, as in trading, you’re going to end up in pretty sorry shape.
But there are some things that serve you well in life that will not help you thrive in the market. In fact, they will hurt you—a lot. One of these things is loyalty.
In life, loyalty is a great virtue. It’s a wonderful trait to have regarding friends and family, great political causes, and baseball teams. Where I come from, you stick by your friends, and you expect them to stick by you. Loyalty to a great cause can change the world—even in our cynical times, it’s hard to deny that the Underground Railroad, the World War II resistance movement, and the American civil rights movement were worthy causes that deserved loyalty. And what can I say about my beloved New York Mets? They may always be the underdogs, but I don’t care. You couldn’t make me a Yankees fan if the Mets never won another game.
But one thing that doesn’t deserve anyone’s loyalty is a stock. I’ve known lots of traders who start to develop a misplaced sense of loyalty to their “favorite” stocks, and, though it might take a while, those stocks let them down every time. Where I come from, if your friends start letting you down, you start to think twice about whether they deserve your friendship. I want to be perfectly clear: No one should feel an ounce of loyalty to any stock, ever. All stocks suck! Think about it! Stocks are not human. They are not your friends. Stocks do not deserve our affection, loyalty, or even trust. The price of a stock often has nothing at all to do with how good the company is, nothing to do with the people that work there. Any sense of loyalty toward stocks is totally misplaced.
The stock market is run by people who play it as a moneymaking game. They don’t care about the companies or the investors, and they sure don’t care about you. What they really want is to take your money. The goal of all stock market players is to make money, and making money always means taking money away from someone else.
As for companies, well, you’d have to be pretty naive to think that they care about you either. Do you think that the CEO of any company cares whether you make money on its stock? Should you trust a company to do things that will make your portfolio more valuable? Of course not. I’d never trust corporate America to look out for my interests, and neither should you.
Stocks can hurt you—badly—and they will never, ever feel your pain. You, and maybe your family, are the only one who will feel it. Less-than-stellar earnings can send a stock tumbling by up to 50 percent in a day. Does the company care if its earnings report loses you money? It does not. And when the market corrects, as it does several times a year, no stock is immune. They will all lose value. You can count on it.
That’s why you have to play stocks both ways. When they’re going up, you buy them long. When they’re going down, you sell them short. They exist as tools for you to make money for the things that really do matter to you—your family, and other legitimate objects of your loyalty. Stocks are the means to an end (use ’em and abuse ’em!), and nothing more. It’s war, and in war there’s only one winner—and it’s got to be us!
Belief that shorting is evil
Some people think that shorting is something only evil people do because it destroys the value of people’s investments and is nothing more than taking their money.
This belief is as misplaced as loyalty to stocks. If there were no forces opposing the irrational exuberance of an out-of-control bull market, stock-price bubbles would be even more extreme than they already are (hard to imagine, isn’t it?). When those bubbles eventually collapsed, the pain would be far, far worse than the corrections we experience.
Forces opposing irrational exuberance are healthy for the market because they help it stay in balance. It’s like letting an opposing opinion have a voice—if there were no short selling, only bulls would be able to have their say, and bears would have no opportunity to speak. The only way to express the opinion that a stock’s price was too high would be to sell it, and that option would be available only to people who already owned it.
Besides fear of infinite loss, the main source of fear in shorting is the fear of the unfamiliar. Shorting is slightly different from buying long, but you’ll be surprised how little difference there really is. As I said above, the best way to get comfortable shorting is to start off virtual—in a simulated account, or on paper—and then small, in your real account. Always short for a reason, and always plan the entire trade. Use limit orders, and always set stops.
That said, I’ve found that there are a few people who, for whatever reason, just never get comfortable with selling short. If you find that shorting really, really doesn’t work for you, then don’t do it anymore. But unless you become utterly convinced that you are constitutionally unable to short, please try to develop this valuable technique. It’s the most important skill to have in a bear market, and it will give you the flexibility to make consistent ka-chingos in any market. Frankly, I don’t think anyone can succeed as a trader without shorting.
Splits
If the stock you sell short has a share split while you’re holding the position, the number of shorted shares in your portfolio will change. When you buy to cover, you’ll just buy the new number of shares. For instance, if you short 10 shares of Tulip Tech’s stock at $200 per share on Monday and it splits two for one on Tuesday, closing at $180, and then begins to trade at its split-adjusted price of around $90 on Wednesday, you’ll find that on Wednesday your account will show a short position of 20 shares at around $90. When you buy to cover, you’ll simply buy 20 shares. (Note that you should have a very good reason for shorting a stock just before it splits, since there is a strong trend for stock values to rise as a split approaches.)
If the stock you sell short provides a dividend in any form—such as money or stock—while you’re holding the short position, you will be required to return that dividend (that amount of money or stock) at the time you return the shares you borrowed. For example, let’s say that you short 100 shares of Kanga Inc. While you’re holding the position, Kanga, as a parent company, spins off its subsidiary Roo Corp. as a separately traded stock. The deal is that everyone who owns KNGA on a particular date will receive one share of ROOO for every ten shares of KNGA held. This means that since you have sold short 100 KNGA, then when you buy to cover, you must also buy 10 ROOO: one share of ROOO for every ten shares of KNGA you shorted.
TRADER TALK Short interest is the total number of shares of a stock that have been sold short and not yet repurchased. A large short interest means that there are many open short positions in the stock, and that a “short squeeze” is possible if the stock’s price suddenly goes up. The short interest on listed stocks can be found at the Yahoo! Finance Web site and others, such as TrendFund.com.
TRADER TALK A short squeeze occurs when some event suddenly causes a stock price to rise, forcing many short sellers to buy to cover at the same time in an attempt to limit their losses. This sudden buying can accelerate the rise in price, causing even more short sellers to rush to buy to cover. A large short interest in a stock can make the effect of a short squeeze quite dramatic.
NEWBIE TRAP Avoid being caught in a short squeeze! If there is no compelling reason to be holding a short position, close it. If the stock has run out of downward momentum and there is no reason to think it will continue downward, it is very dangerous to continue to hold the position. Company news or another event could send the price up at any time, triggering a short squeeze.
Short squeeze.
Chart provided by TradePortal.com, Inc.
WAXIE’S STREET SMARTS
Flexibility is one of the keys to long-term success in trading. After you’ve mastered the skill of making money in a down market by shorting, you can increase your flexibility even more by learning an advanced technique: options trading. Options can be played in a bull or bear market, and can be used to hedge your positions—to decrease your exposure if the market turns against you.
Below are two possible short plays. One is a good short play, and the other is not. Consider all the information available, and decide which is the good play and which is the bad. What are the reasons for the good play? The reasons against the bad play?
I. BARK
The time is 12:30 P.M. The following information on Doggiestock.com has appeared today in Market Views on TrendFund.com:
10:32 ET Mover Of Note: Doggiestock.com (BARK) 6.93 (+1.42), volume 957K.
10:50 ET Doggiestock.com (BARK) 7.71 (+2.20):—Update—Stock reportedly up on favorable mention in the Hoohaw Technology Report.
11:05 ET Hoohaw Report: Doggiestock.com (BARK +2.29) was added to the Hoohaw “Telecosm” portfolio; Burnrate, Inc. (BURN 6.5), HastaLaRasta (OMON 2.26) were reportedly removed due to competition from privately held Solidco.
The NASDAQ tanked immediately after trading opened today, and got as low as 52 at 10:45 A.M. Right now it’s down about 35 points for the day.
You look at the five-day and thirty-day charts for BARK:
The daily chart shows that BARK is now up 3.3 points for the day, as shown on the daily chart:
Should you short BARK at 8.3? What are the reasons for and against the play?
The time is 11:30 A.M. Digital Drek, Inc. (DREK) has been declining for months. Its fifty-two week high is 138, and its fifty-two-week low is 45.0. It is now trading at 55.0 an increase of 2.5 points from yesterday’s low. You can see no reason for the gain—there is no news and the e-tailing sector is cold as a corpse. DREK is a weak company that has never turned a profit. The NASDAQ turned up when trading opened today, and is now up eighteen points for the day.
You look at the daily and five-day charts for DREK:
Should you short DREK at 55.0? What are the reasons for and against the play?
III. Discussion
BARK
Reasons in favor of shorting BARK:
The market is extremely bearish.
The stock has run up over 50 percent on news that does not seem extremely compelling. It has not been added to a major index, but merely to a little-known portfolio.
The stock has been trending downward for at least the past month, suggesting weakness.
The stock has just reached a new high for the day, suggesting that a retreat is likely—at least in the short term.
Reasons against shorting BARK:
Uncertainty as to the long-term significance of the news.
DREK
Reasons in favor of shorting DREK:
The price has gone up for no apparent reason.
The stock has been trending downward for months and is generally weak.
Reasons against shorting DREK:
The stock is trading in a range and has no significant momentum in either direction.
General weakness in a stock is not by itself a good reason to short.
There is no market weakness to drive the stock down.
There is probably a large short interest in the stock, since it has been going down for months. Any news could cause a short squeeze.
It is generally better to short a stock that has just run up too much, given the market climate, than to short a stock that does not have any momentum.
Outcomes
BARK
As shown by the chart below, BARK ended up dropping from 8.3 to 6.5. There were many compelling reasons to play this short, and with stops in place, it was a safe play that made sense.
The best way to play this short was to move your stop buy-to-cover order to progressively lower levels as the stock price moved down (this is known as using “trailing stops”). That way, if the stock turned back up, you would stop out of the position and preserve your profits. (As it happened, the stock did turn back up toward the end of the day, continued to go up the following day, and didn’t stop until a few days after that.) By playing the short from 8.3 to 6.5, your return would be 1.8 points, or over 20 percent. Even if you set your last trailing stop at 7.0 and stopped out there when the stock turned back up, your return would be 1.3 points, or over 15 percent. Either way—bingo ka-chingo! And this was possible on a day when the NASDAQ was bleeding and bruised all day long.
BARK was a good short.
DREK
As shown in the chart below, the stock suddenly went up to 59.4 for no particular reason. Stocks that trade in a range often bounce up and down within their range. If you had shorted DREK at 55.0 and set a stop at five percent, you would have stopped out when the stock bounced to 59.4—a jump of almost 8 percent. When a stock has no momentum either up or down, random movements are certain to occur, and chances are great that you will soon stop out of a position as the price temporarily moves against you. As it happened, the stock move up to above 6 in the days that followed, before resuming its downward course.
The bottom line is that there was absolutely no reason to believe that DREK would move down on this particular day. Therefore, there was no reason to short it. Making this kind of trade is like throwing darts to see where they’ll land. You will never be a profitable trader if you take random positions without justification.
DREK was a bad short. It wasn’t a disaster, but if you consistently stop out of poorly reasoned trades, each at a 5 percent loss, they will eventually eat up your entire account.
