Four Keys to Shorting Stocks Safely

By Quint Tatro  SEP 06, 2011 11:10 AM

It may look like you can't miss by going short now, but traders must always have a technical backdrop from which price plays the pivotal role.

 


The Eurozone may break up, the jobs data was beyond depressing, volatility is high, and seasonality is lending an upper hand to the bears. You survived 2008 and this time want to profit, so with margin in hand you're ready to short stocks with reckless abandon. Well, before you go counting all your money, let's break down a few things.

1. A Technical Plan
Despite all the qualitative reasons mentioned above, it is simply not enough to go out and short stocks. Keep in mind all the negative data that has been sloshing around since the March 2009 lows. Did it work for the bears to short stocks with this data in hand? Absolutely not. So it would be foolish to assume this time would be different. In my opinion the trader must always have a technical backdrop from which price plays the pivotal role. This way there is a level from which you can exit should you be proven wrong. Not a level based on some qualitative economic data that may or may never come, but a level from which a stock or index trades that tells you to exit. Reviewing the general market, the technical read on the short side from my view comes when I observe the weekly S&P 500 as shown below. The index has broken down out of a longer-term uptrend and has started its consolidation. After a bounce attempt last week, a key reversal set in, which gives the short-side trader a clear level from which a stop should be placed. Any move by the index to recover last week’s highs puts the short argument in a much weaker position.



2. Pick Your Spot
It's easy to sit back and say "Short 'em all, they're all gonna fall," when in reality you should have a game plan narrowed down to a few stocks or specific area that you feel offers the best risk to reward. I have observed technology stocks as a favorite among the trading crowd on the long side for some time now. While the general market and many stocks like financials and commodities have experienced fatal death blows during this latest drop, key technology stocks have still offered a relatively safe haven. As we proceed into the fall if this market continues to weaken, I am looking for technology to follow suit.

Take a look at the following technology leaders and their respective chart patterns. Apple (AAPL), Amazon (AMZN), Baidu (BIDU), and IBM (IBM).









3. Index It
The last thing you want to have happen when you're shorting is that your target freakishly outperforms the rest of its peers. Let's say you do all your homework, line up your plan, pick your target, and your given stock then miraculously finds the cure to cancer. Not probable, I know, but anything's possible. Just when you think the group is ready to plummet, your stock flies to the heavens and squeezes you to smithereens. Rather than take this risk, why not use an index or ETF allowing you to short the basket of stocks in the specific group you have targeted? With this in mind I am using the ProShares UltraShort QQQ (QID). I have chosen to go long this inverse due to my technical read on the NASDAQ 100 (QQQ) as shown below. Just like many individual tech stars look to be faltering, so does the NASDAQ 100.



4. Finalize Your Plan
The trading plan I outlined in my book and which I use every day in my fund remains the same. After I have selected my trade based on a technical read, I have established a level from which I would be wrong (stop), I can now quantify my risk and calculate my share count. For example, let's say you were trading with a $100,000 account and willing to risk $1,000 on the trade. After establishing a stop of approximately 2.5% in the NASDAQ 100 -- which would equate to 5% in the QID, or $2.69 based on Friday's close in the QID of $53.79 -- this means you would buy 371 shares of QID, risking $2.69 per share or approximately $1,000.

Remember, regardless of what you may think should happen, anything is possible. At least improve your odds of survival with a clear and quantified plan.

Twitter: @tickerville
Position in QID.