This is another book by William O’Neil, this time specifically on the topic of short selling.
I like how this thin volume delivers the main points in less than 40 pages, followed by about 150 pages of examples with colour charts which can make for many hours of study.
The book gives very good points with regards to shorting stocks, and is a recommended read for any one interested in shorting stocks.
Short Only In a Bear Market
- Sell short only during what you believe is a developing bear market, not a bull market.
- Selling short during a bull market is swimming against the tide, which is rarely profitable.
- Bear markets occur about once every 3 years, and when they do, the decline occurs at a much faster pace than the previous rise.
- After the general market averages show definite signs of weakness, only then does it become a question of the selection and timing of the individual stocks to sell short.
Don’t Switch to Defensive Stocks or Dividend Stocks in a Bear Market
- In a major bear market, they virtually all come down. Stocks that hold up in price and seem to defy a bear market will sooner or later break down.
- It is a fallacy to try to shift your portfolio and buy higher quality blue chips or seemingly defensive issues because they are resisting the downtrend. Money received in dividends can be wiped out in one day’s correction.
- With this strategy you may end up losing less than the market averages, but you still end up losing money.
Market Tops Form in Two Ways
- No Demand – The market averages move up and make a short-term, new high in price on mediocre or low volume, i.e. the demand for stocks is poor.
- Churning / Distribution – There will be suddenly 1, 2, or 3 days where the daily volume increases from the prior day, but the market actually make very little to no price progress (a.k.a. churning) or even close down in price versus the prior day’s close (“distribution days”). When 3-5 of these show up in a 2-4 week period, it’s time to raise cash and re-evaluate your stock holdings.
- After the market averages have topped, you do not have to see a large increase in volume as the market starts to move to the downside for the first few days.
- A top is a process that requires months to complete.
- Companies sometimes report good news, which gives professionals an opportunity to short the “news rally”.
Dealing with Rally Attempts
- Watch to see if the market can rally on higher volume.
- Ignore the 1st 3 days of the rally off a short-term bottom. Genuine upturns will, in 85% of the cases, have a strong price and volume “follow-through” day. This usually occurs anytime from the 4th to the 10th day of the attempted rally when at least one of the major indexes is up 1.7% or more on increasing volume from the prior day.
- A sound follow-through day is generally accompanied by strong breakouts among a number of fundamentally sound stocks.
- Failed follow-through attempts generally offer secondary shorting opportunities.
Typical Faulty Chart Formations Seen at Market Tops – Good to Short When They Fail
- 3rd or 4th “late-stage” bases
- Cup-type formations that form a narrow “V” without putting in time in the bottom of the formation
- Wide and loose price formations with wide weekly price spreads, particularly when compared to the prior 2 or 3 bases in the same stock
- Upward wedging handles that do not drift down but instead “wedge” slightly upward with each successive weekly low closing slightly higher than the preceding week
- Handles within cup-with-handle patterns that form in the lower half of the overall cup base structure.
What Stocks to Sell Short
- Big leaders from the immediately preceding bull market.
- Stocks heavily owned by institutions can suffer if they decide to unload.
- Studies have shown that more institutions own more shares of former leaders as much as 1-2 years AFTER they top than they do during the stock’s big run. Essentially most mutual fund managers are late to the party. This creates huge amounts of potential selling supply as these stocks continue to move lower — everybody owns them, and all that is left are potential sellers who are loaded up with stock.
- Stocks that have recently split, even better if it is the second split during the last couple of years. Splits create more stocks which increases the supply. Oftentimes a stock will top in price after the 2nd or 3rd stock split in a year.
- Choose stocks in industry groups that have topped. Not all groups top at the same time. Look at IBD’s industry group rankings.
What Not to Short
- Companies with thin capitalizations, small number of shares outstanding, small floating supply, small trading volume.
- Stocks with P/E that seems “too high”
- Stocks with rumours of ‘bad news’
- Stocks that are “overbought” based on an overbought-oversold indicator
- Stocks that you have just closed a long position in. It is not always a good idea to reverse.
- Stocks with large short sale interest. Large traders may attempt to run in the shorts during market rallies.
Timing Your Short
- It is better to take time and achieve 1 or 2 gains before attempting to short a number of stocks.
- The point is not to sell short at the top, but at the right time.
- Analyse a daily or weekly chart of the stock. After the first abnormal or serious break in price, there will usually be 2 or 3 rallies in price. This is typically the best point to sell short and should coincide with your timing of the general market averages.
- Oftentimes, a stock will, after topping, have a sharp break to the downside through its 50-day moving average. When that occurs, the stock will often attempt 2 to 4 rallies back through the 50-day moving average to the upside. It is at this point that the stock should be monitored very closely for a sharp, high-volume break back down through the 50-day moving average. When this second break occurs, confirming the downtrend that was set in motion by the first break of the top, you should begin initiating your short position as close to the break through the 50-day moving average as possible.
- The optimal shorting point usually presents itself 5 to 7 months or more after the absolute peak in the stock. There will be late bargain-hunters that will induce several rallies back above a key moving average (e.g. 50-day moving average). These late-comers need to be worn down before the stock will finally break significantly.
- When the 50-day moving average crosses the 200-day moving average and moves below it, a sharp break will often occur within a week to 2 months. Monitor the stock closely after the “cross” and react to the first signs the stock is now going to break sharply.
Chart Patterns to Look For
- Climax / island tops – Stock has rapid run-up for 2-3 weeks (or 8-10 days), often accompanied by upside “gaps”, with wide weekly range (low to high).
- Railroad tracks – In some cases, near the top of a climax run a stock may retrace the prior week’s large price spread from the prior week’s low to its high point and close the week up a little, with volume remaining very high. This is called ‘railroad tracks’ because on a weekly chart you will see two parallel vertical lines. This actually shows distribution.
- Stalling – Stock rallies but closes below the mid-point of its weekly price range for 1-3 weeks on the way up. Watch for stalling action in rallies above the 50-day moving average.
- Wedging – Stock moves up on successively lighter and lighter volume. Signifies lack of buying demand.
- Low volume breakouts – Breakouts from late-stage bases that occur on low volume.
- Overhead Supply – Areas where the stock has traded for a period of time that are above where the stock is currently trading. If stock rallies and moves up into these areas, people that purchased in that area will sell to get out at breakeven.
- Head & Shoulders – Sometimes on the right shoulder, the stock might rally with tremendous volume to run in short sellers. Shorting at the neckline is too obvious, use the 50-day moving average.
Entries and Exits
- To enter, place a limit order half point or so below the last price for the stock. If the market is rallying, place your short selling orders “at the market”. Get your short selling orders in, don’t quibble over 10 or 20 cents. Decide on your stop loss before you short.
- Cover your short when there is a weak or panicking market (i.e. sudden bad news, market gaps down, Pull/Call ratio > 1, VIX ~ 40-70). Cover “at the market”
- Bear markets tend to break very fast and then stage short, sharp rallies which can run you in.
- Don’t use trailing stops. Cut all your losses short when you are wrong or have reached the maximum percentage loss that you set before taking your short position.
- On the profit side, cover and take your profits when the stock declines and hits your predetermined profit percentage objective (20-30%).
Beware of Shorting at Breaks of Support Levels
- Often the best place to cover is right as a stock is undercutting a prior low or area of support.
- Because everyone shorts when a support level is broken, there will be a large number of short-sellers which is a target to be run in by large players who know that the short-sellers would be buyers when they have to cover their short positions. So a stock will often turn and rally from that point, which allows you another opportunity to short.
When to Stop Shorting
- When the bear market has progressed for 1.5 to 2 years, and many former leaders have corrected 70-90% or more off their bull market peaks.