Short Shares – The Basics, Part I of II

What does it mean to shorten an action?

This means that you are borrowing the stock from your broker to sell to a third party. The idea is to buy back the shares at a lower price, returning them to your broker and leaving the remaining cash in your account as profit. In other words, a short seller does not own the stock before selling it. Instead, they borrow it from another investor who already owns it. At a later date, the short seller buys back the shares that he short sold and returns to close on the loan. If the shares have fallen in price since they were shorted, they can buy them back for less than what they received for selling them. The difference is your profit.

Short selling is a transaction made on margin. This means that you must open a margin account to sell short. Most online brokers allow you to open a margin account if you qualify according to their rules and regulations. Criteria related to minimum balances and cash reserves may be applied. You will sign an agreement with your broker to open a margin account, this agreement says that you will keep a cash margin or commit your shares as margin. (Note: call your individual brokers if you have additional questions.)

Going short can be difficult even during a bear market. Conditions must be right for a stock to be considered short. Just because a stock looks overvalued or high doesn’t mean it’s time to sell it short. As I have said before, what seems high to one investor may still be low to another. Two things to keep in mind would be dividends and little-traded stocks. You, the short seller, must pay a share that pays a dividend when this position is activated. Low-volume stocks can be very volatile and market makers and money managers can push the price up quickly by crushing your short game and increasing your overall loss.

If the stock rises above its selling price, you will eventually have to cover your short for a loss. If you haven’t placed a stop loss, stocks may continue to climb as your portfolio heads for disaster. In theory, a stock can increase infinitely, which means that your losses can increase infinitely. Imagine shorting the NVR to $ 200 a share because you thought it was overvalued, only to see it go to $ 700 a share. I am sure that this type of operation would end or leave a big dent in anyone’s portfolio.

Many great shorting opportunities come from the same small and mid-cap stocks that once soared in previous months or years. For example, TZOO and DCAI flew a lot in 2004 before becoming red flags and shorting opportunities. Even large-cap companies like eBay, SBUX, and HD can present shorting opportunities at certain points.

Ideal shorting candidates will have built multiple bases over a long period of time, resulting in bad bases at the last stage as stocks begin to fall. We look for stocks that have built four or more bases over the years, although this is not always necessary. Stocks like mortgage lenders (LEND & CFC) have built many foundations since 2002 and have risen several hundred percent. Home builders are also included in this category, but they have not yet been included in our shorting lists. They have been showing some red flags, but support has been observed at or slightly above the 50-day moving averages.

Additional criteria for short candidates will be slowing earnings and sales and a relative downward force line. Basically, take the characteristics we use for long positions and reverse the criteria to develop a list of potential short candidates. Even familiar chart patterns can be used to spot shorts; the inverted cup-shaped base, head and shoulders pattern and / or flat base with down-breaking action in above-average volume. Industry groups that are weakening or showing multiple stocks falling and breaking key trend lines should be noted on a watch list. If a stock seems like a short candidate, look for additional sister stocks that may have the same configuration. Remember, stocks generally move in groups, whether they go up or down.

I tend to look for stocks that are below the 50-day and 200-day moving averages. Once both lines break through, I look for a strong downtrend and a failure to break above the 200d SMA. This is my ideal time to sell a particular stock.

Always have a strong exit plan with a predetermined stop loss to protect your capital. We normally use a 7-10% stop loss for our long positions, depending on the strength of the market, but I would recommend a larger cushion for short candidates. A stop loss placed at 10-12% from your selling point would be ideal, as most stocks have a natural tendency to rise or contain volatility near the short selling point.

Shorting stocks can be more difficult to learn than buying stocks because a whole new set of bearish short rules and patterns must be learned, in addition to your buying rules and chart pattern skills. Short trading can take many more years to master and can provide a shorter window of opportunity, as bear markets generally do not last as long as bull markets. Regardless of the strategy you develop with short or long positions, you must always adhere to strict selling rules. Never argue with a position that goes against you, emotions and pride mean nothing in the market, especially in the short market. Sell ​​all losers immediately before they devastate your portfolio and your confidence in the future.

The next article in this two-part series will detail the strategies or reasons why you might want to sell a stock short and some examples of how short stocks can benefit a portfolio during bear markets or lateral corrections, similar. to our current situation.