Picking Your Spots When Selling Short

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The action this week got me thinking that I need to write a Duru-like missive on shorting. But since I don’t have a Ph.D you’ll just have to suffer through the following rant which I’ll try to keep relatively short. Yesterday Howard Lindzon wrote:

One thing I have always preached on the blog, less so on Twitter, where I bang out more trading ideas and market thoughts is that shorting stocks is hard. I think it’s harder than any aspect of learning the market. It’s dangerous. Let this morning be the only reminder you should EVER need.

Howard’s right about shorting being difficult. I think it’s so hard because it’s not simply the opposite of going long. (I won’t even go into the whole thing about your losses while short being theoretically infinite. Been theredone that. Use a stop to limit your losses, use proper position sizing, ONLY short LIQUID stocks and you’ll be fine.) What makes shorting tricky is that bear moves often have violent (short-covering) rallies because the psychology of the crowd trading a down market is different than that of a bull market. You have to be quick on your feet when shorting. My motto is “stick & move”.

Many traders love to buy breakouts in bull markets. (Whether that’s actually a good strategy is debatable). In my experience swing trading, the opposite of that strategy, shorting breakdowns through resistance, will often lead you right into a snapback rally and, as MaoXian used to say “the quickest loss ever”. That’s why I often make note of all the people who are initiating shorts after the market has already fallen to a major support level. We saw that this week as I noted in some of the morning watchlists.

My contention is that if you were caught short Friday morning you should consider your losses as tuition paid to the school of hard knocks. Learn from that expensive lesson, take your losses and hopefully survive to trade another day. I’ll stop short of saying that the losses were deserved but there were plenty of warnings to at least cover your shorts if not to get long. There are so many good sources of market information these days, both on the web and, yes, even on TV. I’m not saying to blindly follow somebody else’s opinion but it can be helpful to see what others are doing based on what they see. Here are just a few of the recent warning signs:

  • T2108 dropping below 20 — Ah, good old reliable T2108. I’ve been watching it closely as we’ve sold off. On Wednesday I noted that it finally hit the point where wise shorts would want to cover. It pays to find a good overbought/oversold indicator and heed its warnings. (You may need different indicators or settings for different timeframes.) Sell at overbought and cover at oversold. A couple of years ago I decided to force myself to put some IRA money to work every time T2108 broke 20. It hasn’t failed me yet.
  • The Fed (Plunge Protection Team) has interfered announced stimulus packages around the July lows a couple times. On Thursday and earlier in the week there was talk of more PPT action.
  • The PPT took action earlier in the week and last week. Just look at the orchestration of the LEH and AIG situations, etc.
  • Extreme Volatility — The moves all week were nothing short of violent. Positions were whipsawed all over the place. That in & of itself would be reason enough to lighten up on positions if not move to the sidelines. That kind of volatility is often a sign of a trend reversal, not of a continuation of the previous trend. That’s why so many traders watch the VIX. Tons of people noted the spike in the VIX on Thursday.
  • Corey from the ‘Afraid to Trade’ blog warned ‘Use Extreme Caution in the Week Ahead.‘ He gave many good reasons, including the Federal Reserve interest rate decision, the quadruple witching options expiration and headline risk from troubled financial firms. His crystal ball was working well when he wrote “We could see a week ahead that will be discussed years later – as such, if you are a newer trader, it might be best to switch to simulation mode this week or use this week as a training experience, rather than risking real capital in an environment that could swing violently up and down due to market events scheduled to happen this week.”
  • Bullish Technical DivergencesDr. Brett pointed out some bullish divergences he was seeing in the market. Perhaps most important were what he called ‘those fuzzy indicators’ — “Traffic on the blog is way up, reflecting trader uncertainty and desire for information. I just fielded my fourth media interview request in two days. During quiet and bullish market periods, I don’t get four requests in a month.” On Tuesday morning I also noted my blog’s traffic spiked as did Barry Ritholtz. I’ve often joked about making some kind of sentiment indicator based on my site’s traffic ebb & flow & referral logs. It’s not a bad idea and I think it would be especially useful if it were based on a major financial site’s traffic data.
  • Dennis Gartman telling folks to “be small” — Gartman was on CNBC’s ‘Fast Money’ early in the week saying that he was scared of the market’s movement and he was “being small” and planned to “get smaller”. His advice to others was to “be small” in this market.
  • Jeff Macke, also on ‘Fast Money’ was warning people not to play (trade) if they didn’t understand the (changing) rules of the game. He was referring to all the headline risk from PPT action and the volatility caused by rumors — many of which were spread by CNBC during the trading sessions. Ironically, Macke was kicking himself Thursday night for not following his own advice and getting caught short.

I fully believe that had the PPT not acted on Thursday night the market was *destined* to move higher in the short term on its own. Still being short on expiration Friday in this environment was just asking for trouble. So what’s a trader to do? Like I said earlier, stick & move. I think it makes much more sense to short bounces back to a trendline or moving average. William O’Neil’s book on short selling talks about using retracements to the 50 and/or 200-day moving average as a place to initiate shorts. By the time the stock (or whatever instrument you’re trading) is extended from its moving average it’s time to cover. Then you can wait for another bounce to reload.

The strategy to cover & reload makes more sense when you’re short due to the fact that if you’re dead right with your call on the stock dropping the most you can gain is 100%. The odds of that happening are slim and if it ever did happen you’d likely have to ride out some severe short squeezes. But you might be able to stick & move your way to more that a 100% gain by reloading multiple times. In theory, you could catch 15 10% moves lower in a stock that’s falling, retracing & falling anew.

Short sellers need to be nimble, pick their entry and exit spots wisely and heed signs of impending reversals. Trying to short breakdowns of an already extended market is a sucker’s play — as is overstaying your welcome while short.

Comments

  1. Posted by Dr. Duru on September 20, 2008 at 2:07 pm

    I hereby designate you TraderMike, Ph.D. 🙂

  2. Posted by Michael on September 20, 2008 at 2:14 pm

    Thank you sir ^:)^

  3. Posted by Paul on September 20, 2008 at 9:38 pm

    Nice put-together Mike!!

    “Stick and Move” I have never had a word(s) for it – but it is the sanest way in trading

  4. Posted by Paul on September 20, 2008 at 9:41 pm

    PS. from my experience T-2108 works much better (quicker) below the 20 than above the 80

  5. Posted by Michael on September 20, 2008 at 11:10 pm

    Thanks Paul. You’re right, I don’t use T2108 to try to pick tops. I’ve only found it useful for reversals after steep sell-offs. The crowd psychology seems to be different at tops. They tend to take a lot longer to form. I guess greed (at tops) lasts longer than fear (at bottoms)

  6. Posted by Mike on September 21, 2008 at 12:05 am

    Michael,

    I have to disagree. Shorting is not difficult. Flip the charts upside down, and it’s the same as going long.

    Holding stocks long or short overnight in a highly volatile market… now that’s tough.

  7. Posted by Keith Shepard on September 21, 2008 at 11:50 am

    Excellent post Michael. I completely agree that shorting is not the same as going long. You need to be paranoid to be a good short seller.

  8. Posted by Michael on September 21, 2008 at 11:52 am

    Yes, paranoia is a good quality to have, especially in these times.

  9. Posted by pn on September 21, 2008 at 12:08 pm

    I agree that shorting is different and more difficult than going long. I’ve been playing around with Odds Maker in Trade Ideas testing gap ups and gap downs. So far for gaps downs, I found that it is more profitable to wait until the openning range is broken before shorting.

    For gap ups, I found that it is less profitable if you wait until the openning range is broken. Odds Maker shows that it is more profitable to enter just before the OR is broken.

    One on my preliminary conclusion is that people are more likely to buy double bottoms than are likely to sell double tops.