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.

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