The Key Ingredients Of Successful Short-Selling
I know from
experience and from reviewing many of the questions I get from
TradingMarkets.com subscribers that many of you following my commentary and
techniques have not been using our short-sale criteria diligently or properly.
Investors should realize that so far this year our short-hedges have contributed
half of our total profit — and if we get new lows in the Nasdaq, Dow and
S&P, I would expect shorts to make up the vast majority of our profits this
year. For this reason, I want to review the criteria listed in my book, and in
my 10-week trading
course, with regards to short sales. I also want to cover how
we adjust this strategy if a real bear market appears so that TradingMarkets.com
subscribers are ready and able to pounce on the fast profits that shorts in a
bear market can create.
Each week I comment on all stocks that
meet our upfuel criteria and have broken out of valid 4+ week flags or
cup-and-handles, as well as all stock that meet our downfuel criteria and have
broken down out of valid 4+ week down-flags and down cup-and-handles. Let’s
review those criteria, which we use in all market environments. If you also need
to review how we use breakouts to determine exact entry and exit, please review
my 10-week trading course, free and available to all TradingMarkets.com
subscribers. You may also want to review my book or Science of Trading courses,
available via M. Gordon Publishing through TradingMarkets.com, to become more
expert at implementing this strategy.
Criteria for finding short-sales with
minimum downfuel:
1. Earnings: Either Â
(a) a decline in annual earnings and
an estimate of either an annual loss or another decline in annual earnings,
plus two down quarterly earnings or two negative quarterly earnings;
or Â
(b) two quarterly earnings down 40%
or more, or two negative quarterly earnings with acceleration in the decline;
finally if either criteria “a” or “b” are met, the stock
remains a short-sale candidate from an earnings criteria standpoint as long as
quarterly earnings continue to be lower than year earlier quarters or continue
negative. (For maximum fuel, either the above are met or a stock has two
quarters in a row of declining earnings and declining sales, and a price/sales
ratio (P/S) >10 and PE>S&P’s PE.)
2. Runaway technical market
characteristics down are displayed on the daily or weekly chart.
3. EPS and RS rank both <50.
4. Yield 5% or <.
(For maximum fuel must = 0.)
5. Debt — must have some, the more
the better, over 100% ideal. (Max. Fuel >99.)
6. Funds — must have some
institutional ownership, >30% is optimum. (Max. Fuel
>20.)
7. The worst or second-to-worst rating
by Value Line, Zachs, or Lowry’s rating services.
8. (Max. fuel
only — must be a clear bear market in stocks if stock is related to market —
according to Chartist, BCA, bond/bill/index rules, or PSL systems.)
9. (Max. fuel
only — forming or formed weekly or monthly pattern of Double Top, failed rally,
or Head-and-Shoulders Top and P/S >10.)
This allows us considerably more
flexibility to adjust our portfolio to the U.S. market. We can create a fully
hedged fund — or adjust our short positions to offset as much of our long U.S.
exposure as the market environment dictates. As Julian Robertson said, “Our
goal is to own the best companies and be short the worst companies.” Over
the last decade, our short criteria have helped us to: 1) determine when the
U.S. market is starting to weaken as these stocks usually begin to accelerate
down just before a broad market; 2)Â effectively hedge a broad decline as
these stocks tend to under-perform our longs and the market during corrections
in particular; 3) profit from a bear market, rather than be chewed up by it; 4)
clean-up from a two-way market environment where some stocks are still moving up
or down and others are moving consistently in the opposite direction, as usually
develops during transition periods when the major trend is changing; and 5) get
advance notice of when serious changes in the market are occurring (as we were
able to take 1/3 profits on everything in early March of this year) because
we’re watching the action of both the weakest and strongest stocks in terms of
their respective trends. Thus, while we do not
recommend a fully hedged portfolio at all times, we do recommend covering part
or all of your long exposure via shorts during times when the interest-rate
environment is neutral – negative, when the U.S. technicals are poor, or when
overvaluation is extreme enough that systemic market risk is unusually high, but
an all-out bearish signal has not yet been given. Only when the U.S. and most
global markets have generated universal bearish signals, would we become net
short as part of our allocation strategy.
Like our longs, investors should use
flag-down breakdowns of 4 weeks or more and valid cup-and-handle down breakdowns
of 4 weeks or more as signals of when and where to short stocks meeting the
above criteria. As you get more proficient at locating stocks that meet this
criteria and then looking only for trades in stocks meeting these criteria and
also breakdown out of valid patterns, you can refer to my weekly commentary to
confirm that we’re finding exactly the same stocks and that you’re following the
technique properly. In fact, that’s what my weekly
commentary is for — it’s designed to help those trying to utilize this specific
technique to trade the markets. Many investors at first had questions
as to why a stock they thought met the criteria wasn’t included — but as I’ve
answered these questions over time most investors
following this technique for many months studiously now understand that I am
commenting on absolutely every stock that meets these rigid criteria and that an
investor working hard on following this technique can have very nearly identical
results as the ones reported in my weekly column. Over the first
year-and-a-quarter or so, most criticism and commentary have come from traders
who have not thoroughly studied my courses and this technique. So far, at least,
I have not yet heard from or met a trader who has tried diligently to follow
this methodology religiously who has not been very happy with his/her trading
results.
We basically exit short stocks on:
1) Positive turnaround in earnings; 2)
whenever their PE gets below their expected growth rate; 3) whenever they
violate their 200 MA by 10% or more; 4) take half profits on 40% decline from
entry and then begin using any high with six lower highs surrounding it as
trailing stop; 5) on every new low use ops above correction high as trailing
stop; 6) exit if Relative Strength rank or EPS rank ever move above 50 from
below it; 7) on any weekly chart double bottom or head-and-shoulders bottom; 8)
whenever the stock reacts positively to what should clearly be negative news, or
on positive reaction to restructuring or new management.
Although the odds are now tilting
toward the current (5/00) environment being a bear market, I am not solidly
convinced that we are there yet. It would take new closing lows in the Nasdaq,
S&P and Dow below their respective February-March lows before I will be
fully convinced that we are in another leg down of an ongoing bear market. I
would also like to see at least a week of consistent 20+ number of stocks on our
Bottom RS/EPS New Lows list, and a much higher concentration of valid breakdowns
in stocks on these new lows list. Similarly, I would like to see a large
concentration of specific industries dominate the new lows lists. If we get all
these factors coming together, than for the first time since 1994, investors
will need to look for and allocate more capital to short selling.
The above “downfuel”
criteria for finding short-hedges is valid in a bear market, as in a bull or
sideways one. However, to maximize profit in a bear market (assuming all of the
bear market factors mentioned above come to pass), traders should also look for
major topping patterns in former leaders running out of gas, for about half of
their short-sale exposure. As we get more of these patterns and more of our
typical short-hedge exposure, investors should add about 7% of capital per new
short trade and stop at about 24 positions. You basically let the market
determine the number of shorts and longs by how many valid breakouts or
breakdowns you get. Hold back on adding more than two new positions short or two
new positions long in any one week. Theoretically, you could get to be 200% long
or 200% short in an extremely strong or weak market. To find former leaders
running out of bas, get our your Daily Graphs booklets or look at a huge number
of stocks on a weekly-chart basis. Screen for stocks that are forming six month+
topping patterns such as Double Tops, Triple Tops, and Head-and-Shoulders Tops
over a very long period of time. From this list of potential topping pattern
stocks, look for over-valued equities with a P/S > 3 (ideally >10) and
with a P/E much greater than the last year’s earnings growth and much greater
than the next year’s projected earnings growth. Next, from this smaller list of
potential shorts, look for stocks where earnings growth rates are slowing down.
The big money is made shorting major chart breakdowns in stocks where
expectations have been out of line with reality, that are starting to disappoint
investors that held those out-of-line expectations. Only look for these stocks
when you are very sure that we’re in a bear market. We’ll try to point out some
such issues as examples, should we become convinced that a real bear market is
in progress, in our weekly commentary in the weeks and months ahead.
Most traders have only looked at our
long-side upfuel criteria and buy rules. Now is the time to review our
short-hedge strategies and our aggressive short rules for bear markets. By using
these strategies along with our long-side rules, investors can achieve smoother
long-term returns, higher long-term gains, and more consistent profits in their
stock trading accounts.