Since the success of a short sale depends on the price of the shorted security going into speedy decline in a relatively short span of time, you should consider making a short sale in the following circumstances:
- Bearish trend is developing rapidly – To improve the odds of success on your short trade, the best time to go short is when there is strong evidence that a bearish trend is developing rapidly in a sector or market. While a decline of 20% in a broad index like the Dow Jones Industrial Average or S&P 500 is typically viewed as a bear market, even a drop of 10% is sufficient to set alarm bells ringing for most market participants.
- Fundamentals are deteriorating – This can mean a significant miss on the top line or bottom line for a company, or a string of unexpectedly weak economic data for a broad market index. However, before initiating the short sale, you must ascertain whether sudden signs of weakness are due to a one-off event or are indicative of a deeper malaise; a short sale may be appropriate in the latter case but not in the former. Thus, if a company reports an unexpected loss in a quarter, you should determine the specific reason for the loss. If the net loss was caused by a one-time asset impairment charge, it may only represent a temporary setback; but if the loss was on account of a substantial decline in sales, this may be a clear sign of deteriorating fundamentals.
- Technical indicators are signaling “Sell” – A short sale may also be indicated when multiple technical indicators confirm a “Sell” signal. These indicators can include a breach of a critical long-term support level, a break of an important moving average – such as the 200-day MA – that has been a major support level in the past, a key reversal day, sell signals corroborated by the MACD and/or RSI, and so on. The more technical indicators that support the bearish thesis, the better.
- Abrupt change in momentum / sentiment – The biggest bear markets typically develop after all-time highs have been scaled, as for example the Japanese stock market in the late 1980s / early 1990s, the Nasdaq index from 2000 to 2002, and global equity indices in 2008-09. Investor sentiment and market momentum often changes abruptly right after new peaks have been reached. For a short-seller, while the period of this momentum / sentiment shift is the best possible time to go short, identifying this shift is a monumentally difficult task.
The Bottom Line
An experienced trader may initiate a strategic short position if only one of these factors looks likely to develop. For instance, the trader may take a short position in advance of a struggling company’s earnings report. But for the greatest chances of success on the short side, the optimal time to make a short sale would be when all the above factors are in your favor, which typically happens in the early stages of a bear market.