When the market turns south and starts heading down, as a short term trader you have two options: move to cash or go short.
Well, that’s not true. You could also continue to trade long — and lose a good chunk of your trading capital. For the sake of argument I will assume that does NOT sound like a good idea to you.
Now, when it comes to shorting stocks, there have been some big name retail traders who simply don’t like to short (Dan Zanger, William O’neil, Nicolas Darvas) and there have been those who have made a lot of money shorting (Jesse Livermore, Timothy Sykes).
The only way you will know if it works for you is to give it a try and see.
So let’s get to it!
What Exactly Is Shorting Stocks?
When shorting stocks, instead of buying stock to create a position, you are borrowing shares from your broker and selling those shares on the market.
You are doing this with the anticipation that the value of that position will decrease in value, at which time you would buy back those hares at a lower price, pay back your broker, and pocket the difference.
That may sound a little complicated, but in reality, it’s not much different from buying stock with the exception being your potential gains on the position.
When shorting stocks, the best you could hope for is a 100% gain — and that’s if your position goes all the way to zero. In that sense, you have a return ceiling on your initial investment.
Contrast that with an unlimited upside on a stock that you buy.
To illustrate this, let’s look at this chart of $CSIQ, trading around $4.00 a share.
Now, if you shorted this stock and bet that it was going to decline, the best you could do is if it went to $0.00. Right? It can’t go any further down. At which time you would have earned a 100% return on your money.
Which sounds awesome, and it is.
But, let’s take the same stock at $4.00 and let’s imagine what our potential gains on the long side could be. Hypothetically, there is no limit to how high that stock can go, right?
It can go to $20, $30, $40, or $1000 a share, returning you many multiples of your initial investment.
Do you see? The circle is where you would have opened your position.
Like I said, if it went to $0.00 you would have made a 100% gain on your money. If your investment was $5,000.00, that trade would have returned $5,000.00.
But what if you would have went long? You could have returned 763% on your initial investment, turning that $5,000.00 into over $38,000.00.
Of course, you would have had to stay with the trade the entire time.
Now here’s where you can get into big trouble shorting a stock as opposed to buying a stock.
If you BUY that stock and it goes to $0.00 (assuming you have learned nothing on RetailTrader.info about cutting your losers short and you hold it all the way to the bottom) then you have only lost what you invested.
But what if a stock you are SHORTING goes against you and runs from $10.00 to $50.00 and you don’t get out? Then you owe your broker five times you initial investment.
In reality they will sell your shares before you before it ever comes to that — but you get the picture.
Shorting stocks has a LIMITED upside and UNLIMITED downside. While buying stocks has LIMITED downside and UNLIMITED upside.
Luckily, when it comes to short term trading, most traders are only holding positions for a few days — and in that type of a situation, you can make definitely money shorting.
So let’s take a look at how that can happen, by witnessing…
A Perfect Short Trade
So what would a perfect short trade look like and how you would pull that off? Let’s head to the charts again and take a look.
First, you need to identify a position that you think will be heading lower over the next few days or weeks. Just like going long, there are many, MANY ways to do this.
For the sake of argument let’s say that you like to sell short new lows or breakdowns. As you’re scrolling through a group of potentials you find a stock breaking down perfectly.
Like $PENN below.
Now, once you’ve found your trade, you must see if your broker has shares available to short. That’s because, like I said earlier, you will be borrowing those shares to sell short to other traders who are expecting that same position to rise.
If your broker does have shares available, you will borrow those shares and sell them short. Once you have done that you wait for the trade to develop.
If it goes in your favor, you will close out when your target or trailing stop is hit, pay back your broker, and pocket the difference.
Not bad, right? A perfect trade and a great way to make money in a bear market.
Now, let’s take a look at some of the ways you can place the odds of your trade working out in your favor and how you can side step some of the dangers associated with shorting stocks.
Start With (and Follow) the Market
I say this all the time, but it bears repeating: make sure you pay close attention to the direction of the general market at all times. That means looking at and analyzing the charts of the general indexes.
You should do this because individual stocks trade 4 to 1 with the direction of the general market. Trading in the same direction as the market gives you much better odds of catching wining trades.
This means DO NOT go short when the market is doing this:
Consider shorting when the market is doing this:
Do you get it? You want the odds in your favor. If the market is RISING and 4 out of every 5 stocks is going up, do you really want to hunting for the 1 stock that’s going down?
Sounds like a waste of time to me.
Breakdowns or Rallys?
Now, once you’ve decided that the general market is heading lower (and you are looking for shorts), you need to decide HOW are you going to enter the market.
Meaning, what will your ENTRY be?
Just like with going long, there are pretty much only 2 ways to enter the market short — on breakdowns on rallys? On the long side this would be considered entering the market on breakouts or pullbacks.
Both of these methods are valid and which one you choose will come down to personal preference. William O’Neil in his book How to Make Money Shorting Stocks said that rallys make the better short entry. I have seen both used with success.
To illustrate, here’s an example of both.
Here $KIOR is making new lows and as a breakdown trader you would look for a position.
Breakdown Follow Through
Here $HGG has already broken down but is rallying back to the 50 day MA. Once you see that the rally is failing you take your position.
Rally Follow Through
A final, more dangerous way to look for shorts (at least it will feel that way) is to look for stocks that have had a massive run up over the last few weeks and try to catch the blow off top.
While this method looks and feels dangerous, I have had good success with it. Here’s what it looks like:
New Highs Entry
Here you see this stock has run up nearly 90% in just over a month. The first sign of weakness is a good place to look for a short entry.
New Highs Follow Through
Use Smaller Position Sizes
One way around the threat of infinite loss that comes with short positions is to take smaller position sizes. Not all traders do this of course, but if you don’t want to sit out during bear markets, this is one way to do it.
By cutting your usual position in half and taking shorts based on that position size.
If you feel comfortable shorting stocks you can always increase your position size as the bear market progresses.
Use Time Stops
Another great way to make sure you don’t stay in losing trades forever (and in short positions this can realy damage your equity) is to use time tops.
Set a max trade length of 5 days, 10 days, 1 month. Whatever the case may be, be sure to close out your position when that time comes.
Use Trailing Stops
One method I have found of managing shorts effectively is through the use of trailing stops. Because the market crashes faster than it rises, having a trailing stop that lowers as the position moves in your favor can get you out at just the right time when the position snaps back to the mean.
Of course, trailing stops can also take you out of the market on a normal correction and it’s important to know that there are compromises going in. But when they work, they work well.
For a trailing stop I usually use a moving average or lower highs.
Moving Average Stop
Here you see $SODA broke lower in November and stayed below the 50 Day MA all the way down. If you used that moving average as your stop you would still be in the trade with some very nice gains.
Lower Highs Stop
Here $CNCO also breaks down in November and instead of using the MA, each time a new swin LOW is made, your stop would have been moved to just above the last swing HIGH and you would have followed it down that way.
Of course, these are both perfect charts used to illustrate a point.
The reality is a little more tricky as positions can flail around all over the place before making decisive moves. Welcome to the real world of trading.
Use All of the Above
When I trade I like to use all of the above methods as protection and to get me out of a position.
Time stops, trailing stops and smaller position sizes are all very effective at managing your risk. Take a smaller position size. Use a trailing stop once the position is on. And if the trailing stop doesn’t trigger by a certain day, use the time stop to get you out of the market with your profits.
Don’t Be Afraid to Sit Out of the Market
Finally, if you try shorting and you don’t like it — don’t be afraid to sit out of the market during downturns.
As I mentioned earlier, some very successful traders sat our during bear markets. You can use that time to add more trading capital to your account, to study strategy, to simply do something else.
Like go surfing!
Shorting the market isn’t for everyone. But when the market turns south it’s a good way to take advantage of adverse conditions. Just be sure to use some of th protective methods outlined above and to understand fully the level of risk you are taking.
Until next time…