Shorting Stocks: The Art Of Playing Both Sides Of The Market
Over two
years ago, I published an introductory article on how to short
stocks. Recently (circa March 2001), due to poor market conditions, the interest
in shorting has peaked. Based on this, I thought it would be good time to revise
and republish this article. This new found interest to learn how to short is
probably a sign that the bear market that began in early 2000 is coming to an
end. However, even if that is the case, it’s important that you learn how to
short stocks as markets don’t always go up.
To the public, selling stocks short
can be an intimidating and confusing undertaking. Unfortunately, by sticking
exclusively to the long side of the market, average traders deny themselves the
possibility of improving their returns.
Professional traders, by contrast,
know playing both sides of the market is a crucial element of long-term stock
trading success. We will try to demystify the process by explaining what short
selling is and how you can benefit from incorporating it into your trading plan.
We’ll also show you the rules that regulate short selling, how to know which
stocks to avoid and some ideas about what strategies to use when shorting.
Reversing the rules
When many people think of stock
trading they automatically imagine buying a stock and hoping it goes up. When it
does, they envision selling it and pocketing a profit. For example, suppose XYZ
company was trading at $10 per share. You would buy your shares at $10 (a
“long” position) and sell them later at $12. Your profit from the
trade would be the difference between your entry and exit prices: $12 – $10, a
$2-per-share profit. Nothing complicated here.
But what about when a market is
falling? Short selling is simply a matter of reversing the process described in
the previous paragraph to profit when a stock drops. For instance, suppose XYZ
was trading at $12 but you thought the stock would drop and you sold instead of
bought–that is, you “shorted” the stock. If you later bought your
shares back at $10, you would still have a $2-per-share profit.
Your trade consists of the same
transactions (a buy and a sell) and nets the same profit. The only difference is
that in the case of the short sale, you sell the stock first and buy it back
later–hopefully at a lower price than where you originally sold it.
Why short stocks?
The advantage to selling stocks short
is simple: Bull markets do not last forever, and even in the longest bull market
there are corrections that last from as little as a several minutes to as long
as several months. Those who continued to focus exclusively on the long side
from late March 2000 through March 2001-one of the worst bears market in
history–know this all too well. Professional traders seize these downside
opportunities and profit by shorting stocks. Therefore, if you want to make a
long-term living trading the stock market, it is to your advantage to add short
selling to your toolbox.
What it means to
sell short
In a short selling situation, you
enter a position without owing the stock. How can you sell something you do not
own? The answer is, you can’t. You have to borrow it before you can sell it. For
example, suppose you borrowed what you think is a cheap plate from a neighbor.
Now suppose someone was visiting you and offered you $100 for the plate. You
recognize that $100 is much more than this plate is worth, so you sell it to
him. But now you owe your neighbor his plate–you are, in essence, short one
plate. But as long as you can replace it for less than $100, you make a profit.
Many people have a problem with
selling before buying-it just seems to fly in the face of what is
“natural.” But the short-selling process is really no different than
when you order something and place a deposit. The salesman to whom you paid the
deposit is “short” the product he owes you. As long as he can fill
your order for less than what you have agreed to pay for it, he makes a profit.
From the salesman’s perspective, the deposit ensures you will keep up your end
of the bargain.
Short selling stocks is a similar
process. If you believe a stock is due to drop in price, you put up a deposit
(to cover potential losses) and instruct your broker to sell the shares short.
To do this, he borrows the shares from another account and sells them in the
market. You are now short the stock. As long as you can buy it back for less
than what you sold it, you will make a profit.
Rules and
regulations
The Securities and Exchange Commission
(SEC) has established specific rules regulating the short sale of stocks. First,
you must have a margin/short account with your broker. Your broker can provide
you with the necessary paperwork. Second, the shares for the stock you wish to
short must be available to borrow. Third, you can only sell short on an up tick.
Finally, you must have (and maintain) at least 50 percent* (or more, see below)
of the stock’s value in your account.
Let’s break it down:
1. You must have a margin and
short account agreement with your broker.
A “margin” account allows
you to use stocks you own as collateral; a “short” account allows you
to short stocks. This agreement also allows your broker to “borrow”
shares from you should other traders wish to short a stock you own.
2. The stock must be available
to borrow.
Your broker must be able to borrow the
shares from someone else’s account. If he cannot, no short sale is allowed.
Shorting stocks without first borrowing the shares is known as “naked
shorting” and is illegal.
3. The stock must trade on an up
tick.
This means that the stock must tick
higher before they will allow you to short the stock. If you attempt to short a
stock that trades at $50, $49 3/4, $49 1/2, and $49 5/8, your short trade would
not be executed until the first higher trade in the sequence ($49 5/8). (This
rule was instituted to keep short sellers from manipulating the market.) You
also can short sell on an “equal tick” if the preceding trade was an
up tick. For example, if the stock traded at $50, $49 3/4, $49 1/2, $49 5/8, and
again at $49 5/8, you could short sell on the second trade at 49 5/8-you would
not have to wait for the stock to up tick again to 49 11/16.
Note: At the time this is being
published, the up tick rule is under review.
4. You must maintain at least 50
percent* of the stock’s value in your account.
This deposit is required in order to
cover potential losses. Just as a salesman requires a deposit on something you
special order, the brokers (and the SEC) require that you maintain at least 50
percent of the stock’s value in your account in case your position turns into a
loser. If the stock begins to rise you would have to add more money to your
account (or exit the position). Conversely, if the stock began to drop you could
remove excess cash (or use it for other transactions) as long as you maintained
at least the 50 percent margin in your account.
While 50 percent is the absolute
minimum deposit that brokerages will accept, some brokers may require a larger
deposit. Also, because volatile stocks are riskier, brokerages may require
additional margin on these issues for extra insurance. Contact your broker for
more information.
Short-selling strategies
In general, the majority of patterns
that work on the long side of the market also work (in reverse) on the short
side. For instance, just as pullbacks
from new highs often present good buying opportunities, pullbacks from lows
often opportunities to sell short. As an example, notice Power One
(
PWER |
Quote |
Chart |
News |
PowerRating)
pulled back from lows before resuming its strong downtrend.
More advanced patterns such as my Bow
Ties also lend themselves to shorting. Notice below that Web Methods
(
WEBM |
Quote |
Chart |
News |
PowerRating)
set up and triggered as a Bow Tie (a) before resuming its downtrend.
For more ideas on how to find stocks
to short, refer to Trading The Inverted Cup and Handle, by Loren Fleckenstien
(available mid-March 2000) and other strategies and patterns under Trader’s
Lessons.
Turn The Chart
Upside Down
If you are having trouble seeing these
setups in reverse, then simply turn the chart upside down.. This is exactly what
I did in a article titled How
to Use Inverted Long Patterns To Find Shorting Setups. I pulled a
“Crying Game”* of sorts by showing long setups that were actually
inverted short-sale setups.
Stocks to avoid
Just because something appears
overvalued does not mean it cannot go higher. Many traders were devastated by
shorting “overvalued” biotech stocks in the early 1990s (as many
traders are suffered in the late 90’s by shorting Internet stocks). This is not
to say you should avoid hot sectors all together; it is just a warning to be
cautious and realistic about the possibility of sustained stock rallies.
You should always ask your broker if a
particular stock you are interested in is hard to borrow. Avoid such stocks
because you could easily get caught in what is known as a “short
squeeze,” which occurs when a stock rallies and the short sellers are
forced to cover (exit) their positions. This demand far exceeds the supply and
pushes the stock much higher. If you believe a hard-to-borrow stock is headed
lower, you are much better off buying a put option.
Summary
Shorting stocks allows you to enter
the market as a seller and profit when a stock declines. Your broker
“borrows” the stock from someone else’s margin and short account and
sells it in the market for you. As long as you buy back the shares at a lower
price, you will profit.
To short stocks you must first
establish a margin/short account with your broker. The stock you wish to short
must be available to borrow and you must maintain at least 50 percent or more of
the stock’s value in your account. Also, you can sell stock short only on an up
tick.
Professional traders sell stocks short
because they know markets are prone to corrections and longer-term declines.
Many of the techniques that work on the long side of the market also work (in
reverse) on the short side. Finally, avoid hard-to-borrow stocks and be cautious
about shorting stocks in a hot sector.
*Before entering the position, you
must have at least 50% of the stock’s market value in your margin account. After
you short the stock, you receive the funds for that stock. So technically, you
have maintain 150% of the stock’s market value after you enter the position
(your initial 50% margin plus the 100% of the stock value received). Again,
contact your broker for details here.
Q. Why do people have such a
problem with shorting?
A. Good question. I guess its
human nature to “bargain hunt”. And, when stocks are low they are
viewed as a good deal. However, what most don’t realize that these stocks are
low for a reason and are probably headed even lower.
Q. Is
shorting as easy as going long?
A. Yes and no. From a
conceptual standpoint, shorting should be viewed no differently that going long.
If you have a setup that suggests a stock is headed lower, then you should short
it. From a mechanics standpoint, it’s a little more difficult. First, the stock
must be available to be borrowed (and not considered hard to borrow). Second,
you must get an up tick. These limitations could hinder the execution of the
trade.
Q. Ok, suppose you short a
stock. How do you manage the position? Is it the same as on the long side?
A. For the most part, yes, you
have to take profits and tighten stops as the position moves in your favor.
However, you must keep in mind that things are often torn down quicker than they
are built up. Therefore, profits on the short side tend to come much quicker and
will often evaporate just as fast.
Q. What
about protective stops?
A. Short covering rallies
(those bailing out of short positions) tend to be panicky, especially if it
attracts the bottom pickers. Therefore, protective stops are vitally important.
Q. How did you become
comfortable shorting?
A. As a CTA, I have a
background in commodities. And, commodities are a zero-sum game. This means that
if someone makes money, someone is losing money. So when I was long and losing
money, I knew that the guy on the other end of my trade was short and making
money. For me, visualizing someone on the other end of my trade smiling at the
expense of me made me angry. Due to the leverage involved, you quickly learn
that it doesn’t matter what side you are on as long as you are on the right
side.
Q. Aren’t
you losses theoretically unlimited when shorting and aren’t your profits
limited?
A. Yes, in theory, when you buy
a stock, it can only go to zero. You can’t lose more than you put up. And, of
course, there’s no limit to how high it can go. In shorting, the maximum profit
would be 100% if the stock went to zero. Of course, there’s no limit to how much
money you could lose should the stock mount a prolonged uptrend. This is why
stops and money management are crucial. Let’s say someone is really stupid and
doesn’t use stops. If a stock they were short continued to climb, the broker, by
law, would have demand that they deposit more money or the broker would
liquidate the position. One would think that someone would not be dumb enough to
keep meeting margin calls.
Q. How should one get started?
A. Whenever learning something
new in the markets, I always recommend that you paper trade it first. Be honest,
timestamp your “trades” or use a tracking service. Also, unless you
are using index tracking shares which don’t require an up tick, make sure you
factor in the up tick rule. For instance, you might be lucky enough to find a
stock that drops like a stone but if it never up ticks, you could never actually
held that position. I guess the best way for one to get there “feet
wet” would be to find a stock that’s easy to borrow and trades actively.
The other alternative would be to take a trade in the index tracking shares
(e.g., QQQ) which are easily borrowed and don’t require an up tick.
Q. What about using puts vs.
shorting?
A. I often like using
in-the-money puts vs. shorting a stock outright. With puts you don’t need
an up tick, you don’t have to borrow the stock and your losses are limited.
Q. It sounds to good to be
true.
A. Well, here’s the catch,
options are a complex creature. In many cases, they are so expensive, that even
if the stock moves, the option doesn’t go up in value enough to make up for the
initial purchase. You really need to understand the pricing mechanism and the
volatility of the stock itself. All of this is beyond the scope of this article.
For those interested, you should check out the articles on option trading under
Trader’s Lessons.
*There was a switch-a-roo in this
movie. The “girlfriend” in the movie, had some, let’s say, extra tackle.
Here For A Free 1-Week Trial To Dave Landry’s Daily Swing Trading Alerts
How To Trade Dave Landry’s Best Strategies