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Tips for Shorting Stocks: Do Not Short When...
First, let's talk about what not to do.
Don't short a stock based on valuation. Just because a stock has a high price to earnings ratio (P/E) is not a good
reason for shorting a stock. Other common valuation measures apply, like price to book, price to sales, and well, price to anything. Do not use valuation metrics to determine if the
stock is worth shorting.
Don't short an expensive stock. Stocks that seem unbelievably pricey can get even more expensive. Check out Berkshire Hathaway (BRK-A), Warren Buffett's playground stock.
It closed on 5/7/2010 at $111,500, down $2,000 a share. Just because price has run up a huge amount is not a good enough reason to short a stock. Many traders buy high and sell higher
(momentum plays), so don't try to short against them.
Avoid the sucker short. These are stocks that have risen much too far in price based on fundamentals that seem made out of rumor only. The stock gets lots of media attention for its
quick but large run-up, leaving many to believe the stock just has to drop. It doesn't. If you short the stock, the upward rise will kill you just before the stock finally tumbles.
Avoid the pain by not playing the sucker short in the first place.
Don't short a stock above the rising 30-week (150-day) moving average. The rising simple moving average means upward momentum is still on the side of the bulls.
Never short a thinly traded stock. A good rule of thumb is that your position should be no more than 1% of the average daily volume. If a stock trades 100,000 shares daily, on average,
shorting more than 1,000 shares could be a mistake. I'd avoid a stock with fewer than 500,000 shares trading daily.
Check the short interest. If the stock has a huge short interest, the exit is going to be blocked by traders trying to cover when someone in the theater yells "Buy!"
Divide the short interest by the average daily volume to see how many days the stock has to trade to equal the number of shares sold short. In 1988, when the book was published, Weinstein
said that a common ratio was 3 or 4 (short shares) to 1 (meaning 3 or 4 days of average trading to cover all the shorts). Get nervous about anything above that.
Avoid shorting stocks in a strong industry. You want the market, industry, and stock to all show weakness. If any of the three are strong, you increase your
chances of picking a loser.
Don't short a stock in stage 2. I show where in the price mountain a stage 2 stock belongs in the figure to the right.
Never short a stock without a protective stop. Doing so is a good way to wipe out your account.
8 Tips for Shorting Stocks
If the above list is what you should not do, how do you short a stock?
Short Stage 4 stocks. When a stock is in stage 3, price moves horizontally. A trendline drawn beneath the minor lows will outline support. The 30-week simple moving average
will be climbing up to meet the stock. When price closes below the horizontal (or nearly so) trendline such that it's clear support has been pierced then consider shorting the stock. If a
pullback occurs, then you can initiate a short position once the pullback to support completes and it's obvious that the stock is again heading lower.
Short in a bear or weak market. If the market is rising like oil gushing from a ruptured oil line in the Gulf of Mexico, avoid shorting stocks unless the situation is compelling. If the
market is trending downward (bear market) or stocks are especially weak, then that's the time to short.
Short weak sectors. You can use relative strength to compare industries. Since stocks in hot industries can continue moving up, look for
industries that are especially weak and select stocks from those.
Relative strength should be trending lower. The stock compared to the market index should be trending lower, meaning the relative strength of the stock should show weakness.
The stock should be below the 30-week moving average, and other stocks in the same industry should also be weak (below their 30-week moving averages).
Look for a significant run up. If there is little to reverse, then don't take the short ("the bigger the top, the bigger the drop"). The ideal stock should have an extended
uphill run that is now in the process of reversing.
Look for underlying support. If support is nearby then this stock is not an ideal short candidate. Look for stocks which show sparse underlying support as they make their way
to the top.
If a head-and-shoulders top or other reversal pattern appears, that's good. Look for bearish chart patterns to bolster your confidence about picking a winner.
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