How To Short A Stock
From my previous posts, you can tell I’m losing money being short on a stock that is defying all expectations and has gone up 20% since the day I jumped in. I’ll admit, I’m not too bright and always forget to follow advice which I know to be true. Here’s a strategy that I should try and remember well.
My Strategy for Successful Short Selling
by Jeff ClarkWhen I first started trading stocks, I did so almost exclusively from the long side… only buying stocks.
Through a series of trials and errors, I developed a three-pronged approach for what constituted a good stock to buy:
1. Ridiculously cheap valuation.
2. High degree of pessimism surrounding the shares.
3. Price action that had just turned up following a long decline.As simple as this buying strategy might seem, it has produced superior returns… and it’s the strategy we follow in the Big Trend Report .
Logically, then, it makes sense to use a similar three-pronged approach to betting on a stock falling – called shorting.
1. Ridiculously high valuation.
2. High degree of optimism surrounding the shares.
3. Price action that has just turned down following a steady incline or parabolic rise.Let’s look at each element individually…
1. Ridiculously high valuation.
We all understand that, ultimately, earnings drive stock prices. Consequently, the P/E (price/earnings) ratio is the best gauge with which to measure the ridiculousness of a stock’s valuation.
If you’ve found stock with a P/E ratio 50% higher than the industry average, or more than 50% higher than the company’s historic P/E ratio, then you might have a good short sale on your hands.
2. High degree of optimism surrounding the shares.If every analyst on Wall Street loves the stock… If the anchors on CNBC seem to be mentioning the stock every hour… If all of your friends are talking about the fortunes to be made by owning the stock… Then it’s probably on my list of short sale candidates.
This concept is easy to understand. If the whole world is in love with a stock, and if everyone who wants to own the stock already does, then who is left to push the price higher? If there’s no one left to buy and to push the stock higher, then it only takes one seller to shift the momentum in the other direction.
3. Price action that has just turned down following a period of steady incline or parabolic rise.
Just as it doesn’t make much sense to jump in front of a moving train, it doesn’t make much sense to short a stock as it’s moving higher.
Rather than trying to pick a top in a stock, it makes far more sense to wait until the price action has turned lower – and in the early stages of a downtrend. For me, that confirmation occurs when the stock trades below its 50-day moving average.
Stocks in which the upside momentum is strong will hold above their 50-day moving average lines. Failing to hold above that line is an excellent early indication the momentum is shifting to the bearish camp.
You see, all of the Wall Street hype, all of the CNBC promotion, and all of the persuasive opinions of friends at cocktail parties creates big opportunities for us to bet against over-hyped stocks.
If you stick with these three guidelines, you’ll have all the tools you need to make money on the short side of the stock market.
Best Regards & Good Trading,
Jeff
WCI failed all three tests, its already dropped signficantly and there’s a tremendous amount of pessimism surrounding the stock. I should’ve stayed away! I’m not cut out to trade, which is why I got into real estate in the first place. Like my friend who’s a financial planner says, “Stick with what you know!”.
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September 17th, 2006 at 3:03 pm
I think it was Lord Keynes who said “the market can remain irrational longer than you can remain solvent”.
This is always the challenge with shorting. A rise in price, however irrational, can still kill you. Shorting stocks where companies are repurchasing (even when the cashflows look brutally bad) is a exceptionally ballsy move.
Question though, in an earlier post you said you purchased puts. While this is a bet that the price will decline, it is not the same thing as going short, since your risk is limited to the option premium. Did you buy puts and also short?
September 17th, 2006 at 7:57 pm
I just bought Puts.
I meant short in terms of sentiment.