Shorting Stocks - The Basics, Part I of II

What does it mean to short a stock?

This means that you borrow the stock from your broker to sell to a third party. The idea is to buy back the stock at a lower price, returning the shares to your broker while leaving the remaining cash in your account as a profit. Put another way, a short seller does not own the stock before they sell it. Instead, they borrow it from another investor who already owns it. At a later date, the short seller buys back the stock they shorted and returns the stock to close out the loan. If the stock has fallen in price since they sold short, they can buy the stock back for less than they received for selling it. 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 apply. You will sign an agreement with your broker to open a margin account, this agreement says that you will maintain a cash margin or pledge your stocks as margin. (Note: Call your individual brokers for additional questions that you may have).

Shorting can be difficult even during a bear market. The conditions must be exactly right for a stock to be considered a short. Just because a stock looks overvalued or high doesn't mean that it is time to sell this stock short. As I have said before, what looks high to one investor may still be low to another. Two things to take into consideration would be dividends and thinly traded stocks. A stock paying a dividend must be paid by you the short seller when this position is on. Low volume stocks can be very volatile and market makers and money managers can run up the price quickly crushing your short play and adding to your overall loss.

If the stock rises above your sell price, eventually you will have to cover your short for a loss. If you have not placed a stop loss, the stock can continue to go higher as your portfolio heads for disaster. Theoretically, a stock can rise infinitely, meaning your losses can rise infinitely. Imagine shorting NVR at $200 a share because you though it was overvalued, only to see it go to $700 per share. I am sure this type of trade would wipe out or leave a big dent in anyone's portfolio.

Many great shorting opportunities come from the same small and mid cap stocks that were once high flyers in previous months or years. For example, TZOO and DCAI were high flyers in 2004 before they became red flags and shorting opportunities. Even large cap companies such as eBay, SBUX and HD can present shorting opportunities at certain points.

Ideal shorting candidates will have built several bases over a long period of time resulting in faulty late stage bases as the stock starts to fall. We look towards stocks that have built four or more bases over a few years although this is not always necessary. Stocks such as the mortgage lenders (LEND & CFC) have built many bases since 2002 and have run up several hundred percent. Home builders also fall under this category but have not made our shorting lists as of yet. They have been showing some red flags but support has been noted at or slightly above the 50-d moving averages.

Additional criteria for shorting candidates will be decelerating earnings and sales and a relative strength line heading down. Basically take the characteristics that we use for long positions and reverse the criteria to develop a list of possible short candidates. Even familiar chart patterns can be used to spot shorts; the reverse cup shaped base, the head and shoulders pattern and/or the flat base with a stock breaking out to the downside on above average volume. Industry groups that are becoming weak or are showing multiple stocks falling and breaking through key trend lines should be noted on a watch list. If one stocks looks like a short candidate, look for additional sister stocks that may have the same set-up. Remember, stocks usually move in groups whether they go up or down.

I tend to look for stocks that are below both the 50-d and 200-d moving averages. Once they slice through both of these lines, I then look for a strong down-trend and a failure to break above the 200-d moving average. This is my ideal time to short a particular stock.

Always have a sound exit plan in place with a predetermined stop loss to protect your capital. We typically use a 7-10% stop loss for our long positions depending on the market strength but I would advise a larger buffer for short candidates. A stop loss placed 10-12% from your sell point would be ideal as most stocks have a natural tendency to go up or contain volatility near the shorting sell point.

Shorting stocks can be more difficult to learn than buying stocks because a whole new set of rules and bearish short patterns must be learned, on top of your buying rules and chart pattern skills. Shorting can take many more years to master and can provide a shorter window of opportunity as bear markets typically don't last as long as bull markets do. No matter what strategy you develop with shorting or buying long, you must always stick to strict sell 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 going forward.

The next article from this two part series will detail the strategies or reasons why you may want to short a stock and a few examples of how shorting stocks can benefit a portfolio during bear markets or sideway corrections, similar to our current situation.

Chris Perruna - http://www.marketstockwatch.com

Chris is the Founder and President of MarketStockWatch.com, an internet community that teaches you how to invest your money with solid rules. We don't stop at just showing you our daily and weekly screens, we teach you how to make your own screens through education. Through our philosophy, you will be able to create your own methods and styles to become successful.