Shorting Stocks ? The Basics, Part I of II

What does it mean to short a stock?

This means that you borrow the stock from your broker to sell to a third party. The idea is to buy back the stock at a lower price, returning the shares to your broker while leaving the remaining cash in your account as a profit. Put another way, a short seller does not own the stock before they sell it. Instead, they borrow it from another investor who already owns it. At a later date, the short seller buys back the stock they shorted and returns the stock to close out the loan. If the stock has fallen in price since they sold short, they can buy the stock back for less than they received for selling it. The difference is your profit.

Short selling is a transaction made on margin. This means that you must open a margin account to sell short. Most online brokers allow you to open a margin account if you qualify according to their rules and regulations. Criteria related to minimum balances and cash reserves may apply. You will sign an agreement with your broker to open a margin account, this agreement says that you will maintain a cash margin or pledge your stocks as margin. (Note: Call your individual brokers for additional questions that you may have).

Shorting can be difficult even during a bear market. The conditions must be exactly right for a stock to be considered a short. Just because a stock looks overvalued or high doesn't mean that it is time to sell this stock short. As I have said before, what looks high to one investor may still be low to another. Two things to take into consideration would be dividends and thinly traded stocks. A stock paying a dividend must be paid by you the short seller when this position is on. Low volume stocks can be very volatile and market makers and money managers can run up the price quickly crushing your short play and adding to your overall loss.

If the stock rises above your sell price, eventually you will have to cover your short for a loss. If you have not placed a stop loss, the stock can continue to go higher as your portfolio heads for disaster. Theoretically, a stock can rise infinitely, meaning your losses can rise infinitely. Imagine shorting NVR at $200 a share because you though it was overvalued, only to see it go to $700 per share. I am sure this type of trade would wipe out or leave a big dent in anyone's portfolio.

Many great shorting opportunities come from the same small and mid cap stocks that were once high flyers in previous months or years. For example, TZOO and DCAI were high flyers in 2004 before they became red flags and shorting opportunities. Even large cap companies such as eBay, SBUX and HD can present shorting opportunities at certain points.

Ideal shorting candidates will have built several bases over a long period of time resulting in faulty late stage bases as the stock starts to fall. We look towards stocks that have built four or more bases over a few years although this is not always necessary. Stocks such as the mortgage lenders (LEND & CFC) have built many bases since 2002 and have run up several hundred percent. Home builders also fall under this category but have not made our shorting lists as of yet. They have been showing some red flags but support has been noted at or slightly above the 50-d moving averages.

Additional criteria for shorting candidates will be decelerating earnings and sales and a relative strength line heading down. Basically take the characteristics that we use for long positions and reverse the criteria to develop a list of possible short candidates. Even familiar chart patterns can be used to spot shorts; the reverse cup shaped base, the head and shoulders pattern and/or the flat base with a stock breaking out to the downside on above average volume. Industry groups that are becoming weak or are showing multiple stocks falling and breaking through key trend lines should be noted on a watch list. If one stocks looks like a short candidate, look for additional sister stocks that may have the same set-up. Remember, stocks usually move in groups whether they go up or down.

I tend to look for stocks that are below both the 50-d and 200-d moving averages. Once they slice through both of these lines, I then look for a strong down-trend and a failure to break above the 200-d moving average. This is my ideal time to short a particular stock.

Always have a sound exit plan in place with a predetermined stop loss to protect your capital. We typically use a 7-10% stop loss for our long positions depending on the market strength but I would advise a larger buffer for short candidates. A stop loss placed 10-12% from your sell point would be ideal as most stocks have a natural tendency to go up or contain volatility near the shorting sell point.

Shorting stocks can be more difficult to learn than buying stocks because a whole new set of rules and bearish short patterns must be learned, on top of your buying rules and chart pattern skills. Shorting can take many more years to master and can provide a shorter window of opportunity as bear markets typically don't last as long as bull markets do. No matter what strategy you develop with shorting or buying long, you must always stick to strict sell rules. Never argue with a position that goes against you, emotions and pride mean nothing in the market, especially in the short market. Sell all losers immediately before they devastate your portfolio and your confidence going forward.

The next article from this two part series will detail the strategies or reasons why you may want to short a stock and a few examples of how shorting stocks can benefit a portfolio during bear markets or sideway corrections, similar to our current situation.

Chris Perruna - http://www.marketstockwatch.com

< p>Chris is the Founder and President of MarketStockWatch.com, an internet community that teaches you how to invest your money with solid rules. We don't stop at just showing you our daily and weekly screens, we teach you how to make your own screens through education. Through our philosophy, you will be able to create your own methods and styles to become successful.

Trading Tips No 8: Picking the Best Stock Market Price

Carefully thinking through your goal as a trader is of prime importance, when picking the... Read More

China Syndrome

There has been great condemnation recently because China has been selling its goods on the... Read More

The Right Mutual Funds For Baby Boomers

If you are a baby boomer, time is not on your side. Many baby boomers... Read More

The Inside Scoop on Mutual Fund Rip Offs

The bear market that showed up at the end of 2000 has every brokerage house-as... Read More

Diversification

Wall Street's watchword has always been diversification, but what does it mean and why do... Read More

Trend Trading - Trading Stocks Using Technical Analysis and Swing Trading Strategies

Peter is a professional trader, Paul is not. Peter has a tested, proven, written trading... Read More

Selling

The stock market has been going up for more than 7 months and many investors... Read More

Forces that Move Stock Prices

Among the largest forces that affect stock prices are inflation, interest rates, bonds, commodities and... Read More

Take The Time

You must take the time once a month to review your investment portfolio. It won't... Read More

Inertia

One of the basic laws of physics is that a body in motion will remain... Read More

The 10 Commandments

Wall Street has been preaching for years and years to investors how and where to... Read More

Rebalance And Diversify

The stock market has not been very kind to your investments lately. Your broker knows... Read More

Different Ways of Buying Stocks

Let's say you are interested in this one company. You read its annual report, like... Read More

The Top 10 Reasons to Invest in Mutual Funds

Everyone who follows the financial news has heard of mutual funds and knows the stock... Read More

Staying Sane While Wall Street Crashes

Everybody is riding the Wall Street Roller coaster. Even if you are not invested, the... Read More

Gurgle Gurgle

Caught in a whirlpool and being sucked under. No life vest or other device to... Read More

Market Globalization

Just 30 years ago the stock market was a shadow of what it is today.... Read More

A Common Misconception about Stock Prices

I cringe every time I hear a novice investor tell me that they only purchase... Read More

I Love To Lose Money

Well, not really. What I mean is I don't mind losing a small amount when... Read More

Investing in Stocks and The Game of Monopoly

To begin, you might look at playing the stock market as though you were playing... Read More

Buy and Hold Investment Strategy

"Buy and hold" is one of the most heralded investment strategies promoted today. "Buy and... Read More

Some Good News for A Change

Before we get into all the good news out there, let us first take a... Read More

Political Investing

We have two candidates for president that have really different ideas on how to make... Read More

Race Horses and Mutual Funds

For years investors have been taught to look into the composition of a mutual funds.... Read More

Hot Stock Trader: How to Pick Momentum Stocks with Ease and Simplicity

Most stock traders know that momentum trading can be a very profitable activity. You can... Read More

Lemmings Are Gathering

Before they go over the cliff to their destruction these little furry ones get together... Read More

It Cant Be Done

Wouldn't it be nice if you were only in the stock market when it was... Read More

The Bottom?

Every day I hear someone on CNBC proclaim that "this is the bottom" and you... Read More

High Price/Earnings Ratios and the Stock Market: a Personal Odyssey

After some forty years of banking and investments, I retired in 2001. But since I... Read More

Chart Reading

As an investor you will want to check out any equity before you buy it.... Read More

How to Pay Less and Get More: Discount Broker vs Professional

How do you invest? What do you really pay? At the end of the day,... Read More

Learn to Calculate a Stock?s Pivot Point

Stocks breakout from properly formed bases everyday but many investors don't understand how to locate... Read More

Trapeze Artist - Swinging with the Stock Market

When we go to the circus we see a trapeze artist working on a high... Read More

Patterns

The Law of Chaos is the theory of random unpredictable action applied to the cosmos,... Read More

The Surgeon General

The Surgeon General of the United States says that smoking cigarettes is harmful to your... Read More

Trading Tips No 6: The High Cost of Low Cost Stock Market Information

It has been said that low cost or even free stock market information or trading... Read More

The Great Stock Market Secret

When the stock market is going up and all your stocks and mutual funds are... Read More

No Load Mutual Funds or Exchange Traded Funds (ETFs)?

If you are fed up with early redemption charges and ever increasing mutual fund management... Read More

Roller Coaster

I love roller coasters. The steeper the better. High and fast and curvy. Yahoo! Let's... Read More

Stock Market Diversification

In one of my previous articles (Investing in the stock market -9 powerful tips), tip... Read More

Advisory Service for You?

It depends on your level of understanding of the market and the amount of money... Read More

Investing in the Stock Market - When To!

Is really not as important as to how you invest in the stock market. And... Read More

Hill of Hope

Just about now everyone is confused as to which way the stock market is going... Read More

Invest, Be Wrong, and Make Money in the Stock Market

I have been trading for several decades and was an exchange member and floor trader... Read More

The Seven Mistakes All Novice Traders Make and How to Correct Them

We learnt the following the hard way! If any of these things applies to you,... Read More

Trade Stocks for Real

I read a comment by a forum member on another site earlier today that suggested... Read More

You Wont Like This

Why? Because I am going to shatter your conventional wisdom as I have many times... Read More

Leverage - Margin Debt

What is leverage?Here is a definition of leverage from an online dictionary "leverage - The... Read More

Struggling Stocks, Booming Commodities

04/28/2005NASDAQ dropped -12.5% year to date in 2005. S&P500 index suffered -5.7% this year. US... Read More

Using Sector Funds to Construct Diversified Mutual Fund Portfolios

'Sector funds are too risky.' 'I doubled my money with Fidelity Select Technology in 12... Read More