For traders and investors, knowing when to buy low and sell high is the essence of profiting in the market. But the two steps don’t necessarily have to go hand-in-hand. Traders can profit by selling high and then buying low through short selling. The process is simple enough to understand. Short selling is when a trader borrows shares of a security to sell to the open market, hoping that the price will decline. The trader can then buy back the borrowed shares at the new lower price to capture the profit.
Just as a long position profits off of a stock price moving up, a short position profits off a stock price moving down. Though the concept itself is simple to understand, there are nuances to this approach that traders and investors need to know before engaging in shorting. We spoke with Toni Turner of TrendStar Trading Group this week on the finer details to short selling.
EQ: How can traders and investors profit by incorporating short selling into their strategies?
Turner: During market downturns, overbought stocks with negative fundamentals that rise on the back of a bull market can present ripe opportunities for selling short, as long as all other conditions are in place. What I mean by that is sometimes the rising tide of a bull market will pick up stocks in a particular sector or industry group that are perhaps not as fundamentally sound as the others. Traders will bid them all up, but the truth is they’re overbought in relation to where they should be. Fundamentally weak stocks that have risen to overbought levels on the tide of a bull market can make good shorting targets. Of course, since fear is stronger than greed, stocks fall faster than they rise many times. So if you’re knowledgeable and nimble, you can grab profits very quickly by selling short.
EQ: What are some setups that you look for when identifying a potential short position?
Turner: With Toni’s Market Club, we look for a reversal in an overbought stock like the ones I just mentioned. We also look for a top reversal pattern–which can actually be a similar play, except perhaps it’s an actual top reversal pattern like a head and shoulders or a double top. Another thing we look for is a lagging stock in a lagging industry. For example, recently some coal and natural gas stocks have provided us with shorting opportunities.
As far as setups go, I like to short stocks that are trading just below their 200-day and 50-day moving averages, and then breaking down through prior support from there. I like to short stocks that have a reason or a catalyst for breaking lower, just as I like to buy stocks that have a reason or a catalyst for moving higher.
EQ: Short selling is consider a more advanced strategy for investing and trading than just going long. Can you talk about the major differences in terms of approach and strategy?
Turner: A lot of people will say, “Selling short is just the same as going long, it’s just going the opposite direction.” But that really isn’t true. Actually, it can be very different than going long because price tends to be a lot more volatile when it’s falling. That means it can make really wide price swings when it’s falling. Of course, short squeezes can fuel many of these big moves. A stock that’s falling can make very jumpy, nervous, anxious moves, which can in turn, either wear the trader out or scare the trader out. So these volatile moves can make for a much more difficult trade than if you were just sitting and watching your long position move higher. As well, if you have your stop orders too tight in a short trade, you can get stopped out very easily, but of course, if you have your stops too wide, you can stand to lose more money.
It really is a skill set that traders need to learn, and you need to judge your risk and reward, and stick to it. If I’m going to make a swing trade short, I leave my initial stop in place for sometimes one to two days, and then lower it. I rarely stay in a short position for more than three days. That’s my outside limit. If a stock hasn’t fallen by then and delivered a profit, then I misjudged it and I want to get out before it makes a wild move to the upside. Many lessons that I learned in trading, I had to get knocked around many, many times before I learned the lesson. But getting caught in a short squeeze, I only had to learn that once–it was that painful.
EQ: Can you talk about the importance of using stop orders to help traders and investors avoid or protect themselves from risks when entering short positions?
Turner: Stops are extremely important because while price can only go to zero, it can theoretically go up forever. This means that theoretically, the risk of a short trade is unlimited. There are simple ways of deciding where to set stops. For example, you can use one or two ATRs (average true range) and put your stop above those levels. Or, you can place your stop 2 percent or 3 percent above the high of the day where you entered. There are all kinds of places you can put your stops.
When you sell short, you don’t want to fight the tape. You want the market heading lower and you want everybody in your corner. You want the industry group or sector where your stock lives to be weak, at least on the entry day that you’re getting in, with the potential of falling lower. One of the biggest mistakes traders make is they will sell short a lagging stock in a leading industry group. This can be potentially dangerous because when all of the leading stocks in a leading industry are all bid up, traders will go looking for second-tier stocks to buy, and those will be the lagging stocks. So it’s not always a good idea to do that. Again, don’t fight the tape, and make sure the sector or industry group that your stock resides in is moving down. So set your stops and don’t start raising them. You don’t want to raise your stops, or ignore them. If you get stopped out, then you get stopped out. Look for another position or re-evaluate what you’re doing. Timewise, traders may also plan is to not be in that trade as long as they would be in a swing or position trade, because the potential for a short squeeze, or a rapid price move higher, can gathers steam, over time.
EQ: Is it ever a good idea to hold a short position as a hedge for a longer-term investing strategy or portfolio?
Turner: Absolutely. Let’s say, if you have a long position in an IRA, and you want to keep it through a potential market pullback, you can certainly sell short that position or sell short a correlated exchange-traded fund in a separate account to hedge that trade. Since you can’t sell short in an IRA, and you need a margin account to sell short, you won’t be able to do it in the same account. In any case, there are a lot of different ways to do use a short strategy as a hedge. Of course, a lot of people use options to hedge as well, but for people who don’t use options, selling short is certainly a way to go.