Some Pitfalls of Short Selling

You know bull markets end just when everybody and their brother decide to enter the stock market. Mania brings in any and all people that think there is a quick buck to be made. Bear markets end the same way, when any and all average investors give up and cash out. Or worse, think they can make money by shorting stocks. It is about the end of the bear market when these average investors finally realize there is a way to profit from falling stock prices but by the time they find out, the downtrend is ending. These people will always lead the charge and flood the market in a bull’s final days and be the last to leave the market or start selling short in the bear’s final days. So, now you know that it will be time to go long in a big way when the public finally gets around to selling short.

Short selling can be very profitable if done at the correct time, but can be very frustrating if entries are not perfectly timed. It is never easy to make money in the stock market and selling first, and buying later (short selling) is probably the most difficult way to succeed in trading. In fact, most traders can study a stock chart that is plummeting for hours, and still enter a short sale exactly at the wrong time.

Tonight we will look at some common pitfalls of the short selling trading strategy. After you review this list, you'll understand why short selling can cause so much mental and financial pain and stress.

1. Volatility
A bear market has tremendous overlap in daily price ranges of stocks and indexes. The daily high and low of a stock in a bear market seem to be more volatile in that of a bull market. These wild intra-day trading ranges can make it difficult to trade and set up trades for the next day. Usually, stocks will trade through a portion of the previous day’s range undermining logical stop placement, and makes good entry prices harder to find.

2. Nowhere
Fast Stock prices don’t go anywhere most of the time in bear markets. Though there is intraday volatility, markets will often end flat. Then out of nowhere, prices decline very quickly and in sudden bursts. This means you need to wait around for a while before you get the big sell off that gives you the big gains. Most people are too impatient to hold short positions for a lengthy period of time.

3. Everyone is at the party
Short selling is a terrible group activity. Many stocks have a high short interest and attract latecomers. These latecomers will be scarred out of their shorts as soon as the stock starts to go up. This will result in frequent short squeezes as the weak shorts bail out for a loss, regardless of how technically bad the chart looks. If you short with the crowd, you become most exposed. Don’t short the same stocks as everyone else.

4. Misguided Entries
So you think you're a wizard when it comes to resistance levels? Not so fast. Here’s why: support-resistance is what most traders are looking at and remember, the market always disappoints the majority. This is why price will often go further than you expect, up and down. You could find yourself shorting into bear rallies that keep on going up, and up and up until you give up and cover your position well above resistance. Stocks overshoot resistance and support more times then we’d liked to admit.

5. Too Late Harry
It's often too late to sell short by the time most people realize they should because the sell off is gathering steam. The smart money that shorted from higher levels are already looking to cover by the time most people think it's safe to sell short. The traders that shorted at the top add buying power to the market when they close their positions. That's why the people late to the party short at the bottom and get crushed on a short squeeze.

6.Bill Fleckenstein strikes again
It's the end of the world, stocks should be going down, there is no good news or catalysts to drive stocks higher so you better get short. But, ask yourself “How does the chart look?” You may hate a company and think it's on the verge of collapse and you want to get short to take advantage of the stocks decline. If fact, the whole market should be going down because of the terrible economy. However, none of that matters unless the stock chart is in a down trend. You could be way too early entering your short position based on what you think the stock or market should do. Instead, take a look at the chart. If the stock is still in an up trend, DO NOT take a short position no matter how bad you think you want to.

7. Cat and Mouse
The cheese sure looks appetizing, but there is a spring-loaded mousetrap just waiting for the next short seller. The most obvious selling points on the chart routinely trigger the most violent short squeezes. When it’s too obvious, it will most likely not work.

8. Unbearable Market
Are you sure we are in a bear market? Just because the market looks and feels like a bear market on the daily charts does not mean it is a true bear market. Look at the weekly charts to determine if the trend has changed to down. Many stocks will trade sideways for a long period of time and consolidate in this manner sometimes pulling back from higher levels. This can sometimes look bad on a daily chart but when looking at the weekly charts, this tends to be normal consolidation in a bull market. These charts reveal a balance of buying and selling power, rather than a one-sided rout.

9. Look at the Calendar
Profits from short selling sometimes depends on the time of the month. For example, positions entered around option expiration get burned because of all the put/call unwinding. Also, buying power can surge near month's end, especially during mutual fund window-dressing season. This can make a falling market snap back and look powerful just enough to shake all the weak shorts out. It happens every month around options expiration with uncanny effectiveness.

Conclusion
Please don’t misunderstand this commentary. We are not against shorting stocks, it’s great way to profit from falling stock prices. All we are trying to do here is help you realize and understand the possible pitfalls of such a strategy.


David Colletti
Founder
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