Sunday, January 6, 2008

How I Find Shorts

Since all evidence points to the stock market being in the midst of a possible bear market or at the least an intermediate-term correction, I thought I would write a bit about how I find possible shorts and trade those possibilities. If you read my last post, you know that it is a little too late right now to short unless you love taking huge risks, but a time will come soon when the market rallies on weak volume and puts many stocks back in perfect positions to short. As with any other market strategy, patience and discipline is extremely important to successfully shorting.

I want to start by saying the strategy I used is based on William O'Neil's book "How to Make Money Selling Stocks Short". I would definitely recommend reading it to get a better idea of how to do this correctly. I have taken the basic idea from that book and adapted it a bit to my own tastes, basically making it a shorter-term strategy. The basic idea that O'Neil writes about is shorting stocks on weak rallies during bear markets rather than strong breakdowns. The main reason for this is because the market has a natural inclination to go up, so stocks that suffer major breakdowns below support will usually have buyers come in, thinking that the former leader is now a "bargain". This doesn't mean these breakdowns aren't significant or that the stock isn't going much lower. It just means that shorting breakdowns will often get you caught in a quick, bear market counterrally that will get you stopped out. And bear market rallies can be very short and very powerful, usually caused by some short squeezing. I am sure there are many people who make a lot of money shorting breakdowns the same as buying stocks on breakouts, but I think watching for weak volume rallies back into points of resistance is a much less risky way to establish short positions.

O'Neil also emphasized that timing is extremely important when shorting, especially when focusing on the former big leaders from the prior bull run (which are the exact stocks you should be looking at to short). After a stock has made a huge run and made a lot of people a lot of money, it will start to break down, as I believe some stocks like AAPL and RIMM are starting to do now. However, there were no doubt many people that missed the big runs in these stocks, and the regret that goes with missing out on a stock causes them to look for chances to still get into the stock, hoping to catch some of its run. So the first few times a big-time stock breaks down, there will likely be buyers below preventing it from totally crashing. If you want proof of this, watch CNBC (at your own risk) in the next few weeks and look at how many people will continue to pump AAPL, GOOG, and all of the past leaders as "great buys" now based on their PE and fundamentals and stuff like that and ignore the price and volume action of the stocks. These "bargain" buyers will cause the stock to rally one, two, three, even four times back up before the bullishness that was once so strong in the stock finally dies out. It is at this point that the stock will finally go down in earnest, and it is also at this point that a short should be initiated.

So after a stock breaks down for the first time, you start looking for some signs that it may be shortable. What I look for is how the stock rallies and where the rally takes it. I particularly pay attention to the 50 day moving average and the volume of the rally. As a stock comes back near its 50 day, I will look at how much volume there was on its rally compared to the first breakdown. I also like to use the Moneystream indicator from Telechart to spot possible negative divergences in the stock as it approaches the 50 day MA. If the signals line up properly, I will start a position when is very close to the 50 day or when it gets just over it. This allows me to have a close stop-loss point if it does continue to rally, and I can add more if the stock does move lower. It is impossible to tell what rally will be the final one, so there is a little bit of anticipation involved, but as long as you set a stop-loss point, it is relatively low-risk. You also have to pay attention to the general market and where it is at. If it has also rallied weakly for several days, you may be approaching a point to add some shorts. I try to take at least some profits around 10%, because of the way bear markets rally quickly. I will cover and then look for another rally to get short again. Of course, I will learn as I gain more experience on this side of the market, so I hope my techniques will improve over time.

Here is a chart of GRMN, a stock I have made a little money on shorting the past month or so. I covered my short last week, because I expect another rally sometime soon - probably to up around $100. But it was a former leader, had huge volume on its downmove, and rallied weakly - exactly what I look for.

Chart from Telechart2007, Courtesy of Worden Brothers, Inc.

I keep track of possible short candidates in Telechart in two ways. I have a watchlist called "Former Leaders" that I check daily. On this list are AAPL, GOOG, RIMM, GRMN, BIDU, VMW, EXM, DSX, TBSI, DRYS, FTK, CRNT, GES, and FMCN. I add more if I see some, but I get these mainly from looking back at old IBD 100 lists. Most of these stocks have broken down or are starting to break down, so I will watch for the type of pattern I described above and act accordingly. I also created an Easyscan in Telechart that helps identify stocks that have rallied up close to their 50 day MA. This scan is by no means perfect and I continue to tinker with it, but each day it gives me another 30 or 40 candidates to look through each day to check as possibilities. I created a PCF and called it short scan. The scan is as follows:

C >= (AVGC50 * .95) AND C < (AVGC50 * 1.05)
This gives me stocks that are within 5% of their 50 day moving average. From there I add that condition to an easy scan and also include the following conditions;

Watchlist: All Stocks
Price Growth Rate, 1 Year: Rank 55 to 99
Price Percentage Change 26 Week: Rank 6 to 62
Volume 1-Day: Rank 51 to 99
Price Per Share: Rank 16 to 99
Price Percentage Change 5-Day: 75 to 99

What this scan basically gives me is stocks that are up or flat on the year, have gone down at least five percent over the last 26 weeks, and whose price has not gone down the past five days or has rallied, as well as being within 5% of their 50 day moving average. This scan gave me BID as a possibility last week, and COH as a possibility a few weeks ago.


Chart from Telechart2007, Courtesy of Worden Brothers, Inc.

Unfortunately, I did not take either because I was too busy trying to be a hero shorting solar stocks. I didn't lose more than a few percentage points on each short, so it was not a big deal, but it does bring me to my final point - only short weak stocks. I debated between taking BID and TSL last week and went with TSL. I was stopped out that day. So I still need to work on my discipline with shorting. Short weak stocks. Short weak stocks. Short weak stocks. I can't say that enough, and maybe I am saying it so many times to get it in my head too.

I hope this helps some readers out there. I will continue to work on this and will certainly make mistakes, but will also learn from those mistakes. Again, it is now much too late to short stocks in the short-term, but longer-term, all evidence points to the market going much lower from here, so opportunities will arise. Watch for those bear market rallies and be ready to pounce when a weak stock gets near its 50 day moving average. Good luck next week.


Asunder said...

Even though that book (How to Make Money Sell Stocks Short) gets a lot of criticism, I have enjoyed it. I actually bought it solely for the charts in order to familiarize myself with shorting better, but the commentary is quite good as well.

I was reading the monday edition of IBD and saw the stock TIE which was a market leader up until 1-1/2 ago. It staged a climax top, broke and formed a deep (50%+), wide and loose cup-with-handle. It hasn't done much of anything other than trade sideways for about a year, but it did break its base support level today on avg volume. It's something to watch for a short near the 50-day. I drew up a chart if you're interested:

By the way, how well do those proprietary TC2000 indicators work in your experience? I have experimented with everything from stochastics, RSI, MACD, etc. in the past, but haven't found anything really useful in determining short-term price dynamics.

Mac said...

TIE is definitely past its shorting point right now as you stated - early Dec was probably the right time to do so.

I have only be using Telechart for about two months or so but I can already see how they can be useful. I like how the moneystream can show if a price movement is legitimate and through my experiences so far they have worked pretty well. I followed a blog for several years that swore by the BOP indicator when looking for longs. Doesn't look like we'll need that for a while however unfortunately.