Short selling takes a skill that capitalizes on the mechanics of when a market transitions from higher to lower prices. The steep learning curve intimidates traders and investors, leading them to avoid it entirely, even in bear markets. But this classic strategy can be profitable through uptrends and downtrends as long as strict risk management rules are followed and timing is carefully managed.
Of course, it’s easier to profit from short sales in downtrends because, as Martin Zweig wisely says in his 1986 classic Winning on Wall Street, "the trend is your friend". (For more, see: Investing Quotes You Can Bank On). Despite the advantage, short sellers get targeted relentlessly in bear markets, often trapped in violent squeezes that blow out the most carefully placed stop-losses. This reality check tells us that long term profitability requires more just than throwing money at a falling security. (See also: Keep It Simple - Trade With The Trend).
Short sale mastery needs simple entry strategies, perfect timing and defensive trade management. Sellers also need to adopt rules that enhance these strategies while lowering the risk of getting caught in a short squeeze. These aren’t fail-proof because it’s natural for sellers to incur shock losses from time to time, but the trick is to minimize these unpleasant parts while finding aggressive ways to ride prices to lower levels.
Three Short Sale Strategies
You can sell short at any time in a liquid market that has no special restrictions. The current version of the US uptick rule doesn’t come into play until a security has already fallen 10% so it’s rarely a factor in deciding to sell short. Theoretically, the broker must have the security in inventory when another customer takes the short position but in reality, naked short sales without corresponding inventory is now a widespread practice due to competitive business practices.
Profitable short sales tend to follow one of three techniques:
Of course, many traders choose to sell short at new highs, thinking a security has risen too far, but this is a recipe for disaster because uptrends can persist longer than predicted by technical or fundamental analysis. In fact, the large supply of weak-handed short sellers in strong uptrends provides rocket fuel for even higher prices. All it takes is a few upticks and these traders start to cover, triggering a cascade effect that can add a lot of points in a relatively short time frame.
Ford Motor (F) showed three profitable short sale strategies in a single downtrend. The automaker carved the last leg of a bearish double top pattern in September and broke down, triggering bearish signals that momentum traders can use to sell short. The decline ended quickly, giving way to a bounce that failed at broken support, allowing pullback players to get on board. Price drifted back to the weekly low within an 8-day consolidation, encouraging range shorts to take positions. The stock then broke down, setting off a sequence that repeats entry signals for each strategy.
Despite this perfect example, short sale entries carry significant risk that requires perfect timing. (For more, see: Short Selling: The Risks). It’s easy to chase a downtrend, getting filled well below the breakdown level and getting caught in a normal retracement. Pullbacks work well, but modern algorithms often push price above a broken level to squeeze shorts and draw in weak-handed buyers, before resuming a downtrend. And, as on the Ford chart, the September bounce could have filled the breakdown gap above 17 without impacting bearish technicals, rather than reversing right at the August low.
Short Sales Do’s and Don’ts
Short sale performance can be improved with the following rules that lower risk, while focusing attention on the most promising opportunities. Note that chasing lower lows in a momentum strategy should be scrupulously avoided until the short seller has developed a proven skill set verified by bottom line profit and loss. This is an important restriction because these positions often get filled at the worst possible prices, due to algorithmic front running.
- Short rallies, not sell-offs - Your first job as a short seller is to avoid the crowd at all times, while using their emotional energy to get positioned at the best possible price. Countertrend bounces offer ideal conditions for selling short because you know the price where other sellers are likely to reload positions. The risk comes if that crowd is bigger than the crowd buying the broken security, hoping for a new uptrend. (To learn more, see: Momentum Trading With Discipline).
- Short the weakest sectors and market groups, not the strongest - Let other traders get a case of vertigo, staring at explosive uptrends, thinking the security is too high and must fall to earth. A better plan identifies weak market groups already engaged in downtrends and uses countertrend bounces to get on board. Surprisingly, these issues often carry lower short interest than a typical hot stock, making them less vulnerable to squeezes.
- Watch the calendar and avoid bullish seasonality - Short selling around holidays or during options expiration week can incur painful losses because those markets don’t follow natural supply or demand. Also avoid short sales in low volume conditions, following the old wisdom to "never short a dull market". (Check out the most bullish times of year in: Incorporating Seasonality Into The Trading Day).
- Short confused and conflicted markets - Take short positions when major indices pull against each other. (See: Read Market Trends With Convergence-Divergence Analysis). These conflicts generate bearish divergences that set off sell signals when instruments sync up and point downward in unison. In addition, sellers can use relatively tight stops that keep losses under control if alignment points higher.
- Avoid big story stocks - Traders love to sell securities with colorful and questionable stories that dominate the financial press and media, thinking they’ve uncovered an instant moneymaker, but these issues attract a massive crowd. In turn, the security incurs high short interest, significantly raising the odds for vertical squeezes even in virulent downtrends.
- Protect against failed breakdowns - New downtrends can get tested relentlessly. (See: How To Trade & Profit From Pattern Failures and Master A Breakout With Three-Step Market Mechanics). Know your cover price when a downtrend returns to the breakdown level, placing a physical stop whenever possible. There’s little advantage in taking a loss after the position has moved into a profit so the stop should go no higher than your breakeven price.
The Bottom Line
Short sales work well in bull and bear market environments but strict trade entry and risk management rules are required to overcome the constant threat of short squeezes. In addition, the short seller must do continuous reality checks to confirm they’re not a member of the crowd being targeted for pain.