4 Things To Consider When Shorting

  • August 11, 2004
  • Rob Hanna

After
a huge gap down and morning selloff, the market did manage to put on
a brave face and rally a little during the afternoon. The S&P and Dow came close
to getting back to breakeven for the day. The Nasdaq didn’t do nearly as well
and finished down about 1.5% for the day.

 

There has been a lot of talk
lately about whether we are in a bear market. From its high in January to its
low today, the Nasdaq is down over 18%. The S&P, meanwhile has only dropped
about 8% from its highs (which came in March.)  While I can’t answer whether
this will become a full-fledged bear market, we are definitely now locked in a
downtrend – a downtrend with rather broad-based selling, as nearly all areas of
the market seem to be acting poorly. How long it will last and how deep it will
go is anyone’s guess. It appears much more likely to me that we will see further
downside before any new bull leg will assert itself.

 

Most traders understand that it
is easier to make money shorting stocks in a bear market than it is buying
them. What traders should also be aware of is that it can be much more difficult
making money on the short side in a bear market than on the long side in a bull
market. One reason for this is that the risk/reward is typically not as good on
the short side (for intermediate-term positions). 

 

The 2nd issue is the
propensity for the market to have exceptionally sharp rallies during longer-term
downtrends. Few things illustrate this point better than to see that 9 of the 10
best days (percentage-wise) in the history of the Nasdaq occurred during the
2000-2003 bear market. These included days like 1/3/01 (+14.2%), 12/5/00
(+10.5%), 4/5/01 (+8.9%), and 5/30/00 (+7.9%). Incredible up days that are
forgotten by most because they occurred within the context of a historical bear
market.

 

If the market does continue to
worsen, I would definitely continue to look for opportunities on the short
side. Make sure you do a few things, though, when considering managing your
portfolio net short:

 

1) Don’t get overextended on
the short side. Know the outstanding risk of your portfolio at all times.

 

2) Manage your positions
closely. Always know your stop price. 

 

3) Take partial profits when
huge drops occur. Profits need to be booked when available.

 

4) Focus on shorting when the
market pulls back, not when it is already oversold.

 

Sharp rallies will occur in
downtrends. Make sure you do what you can to make sure they don’t sting you too
bad if you’re net short.

 

Best of luck with your trading,

Rob


robhanna@rcn.com