A Systematic Approach to Shorting Stocks

Posted by Wayne on February 12, 2008 – 5:35 pm

The article you see below was not written by me or anybody else at TickerHound. In fact, while you would never know it from the quality of the article, it wasn’t written by any “professional” investors or money managers. No sir, the article you’re about to read and learn from was written by two TickerHound members who I’m sure you already know rather well…

EthanR and ChaosNantuko!!

Ethan and Chaos (Jordan) approached me a few weeks back wanting to know if they could contribute something really unique and special to the TickerHound community. They felt that their contributions to the site, while good, couldn’t possibly give them the flexibility they’d need for the project they had in mind. They wanted to collaborate on a trading system that would allow anyone - and that means you sitting at home reading this right now - to systemically short stocks and profit from it.

So I said, go for it!

And below is what they came back with. Now, just to be clear, this is NOT a recommendation to buy or sell any particular stocks. It is merely a system that Ethan and Jorden devised that they found to be successful and wanted to share it with you and the other TickerHound members.

So enjoy it, learn from it and even comment on it right here on our blog. I know Ethan and Jordan will appreciate and welcome the feedback.

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A Short Term Method For Shorting Stocks

By Ethan S. Roberts and Jordan J. Weir

Introduction:

The authors’ intent is to develop a method for shorting stocks over a fairly short term period of time, defined as anywhere from a half hour to three days, in which the potential for maximum profit is enhanced, while the risk of loss is minimized.

Investors short a stock when they believe that the stock is weakening and will soon decline in price. The Shorting Process is defined as:

“An investor who sells stock short borrows shares from a brokerage house and sells them to another buyer. Proceeds from the sale go into the short trader’s account. He must buy those shares back (cover) at some point in time and return them to the lender.”

http://www.fool.com/FoolFAQ/FoolFAQ0033.htm

In the past, market rules dictated that you could only short a stock on an uptick, ie. a rise in the most recent price of the stock, prior to entering your short position. However, that rule has recently been changed, and that change allows for greater profit potential from shorting a stock because one can short a stock while a declining trend is already in progress.

One will often hear that shorting stocks is extremely risky because unlike a long position, which can only go to zero, a trader entering a short position could be the victim of a stock going to infinity. However, let’s take a closer look at the real level of risk. First, realistically, how many stocks go to infinity? Second, this belief does not take into account the ability of one to cover their short position in advance with the use of stop loss or stop limit orders, or to simply cover with a market order if absolutely necessary. Third, stocks tend to rise and fall, not go up in price indefinitely. In fact, stocks that rise too fast, in chart terms a “parabolic spike”, tend to fall in price much faster than stocks that rise more slowly.

Shorting stocks can be more profitable than holding long positions if done correctly. Stocks will usually drop in price faster than they increase, and declines are more often to the extremes, than are advances.

Caveats:

Keep in mind that stocks below $5 may not be shorted, and in order to short stocks, one must open a margin type account with a broker. There may be fees involved, and one should check with their broker as to what those fees may be. All trading, especially shorting, can involve risk, and readers are strongly urged to consider that risk if they decide to utilize this method. As our goal is to minimize risk, we do not advocate using margin, but rather maintaining enough funds in the account to cover the trades. The results presented here are non-leveraged results. While using the 4:1 leverage afforded to day traders would theoretically boost returns, we do not recommend the use of leverage to our readers. Each loss will also be increased, and it takes a larger % profit in absolute terms to cancel out a % loss. (If you lose 50% of the portfolio, it takes a 100% gain to get you back to break even). It is also likely that you will need to have a minimum of $25,000 in your account, as the brokerage may deem you to be a “pattern day trader” if you are making at least one trade per day in this manner. The link below explains this term.

http://en.wikipedia.org/wiki/Pattern_day_trader

Since trading decisions are often subjective in nature, even when using objective criteria, our past performance is not and can not be a guarantee of future results for anyone else.

METHOD
We would like to make it clear from the beginning that the following is a “method” and not designed to be a system with rigid rules. It is said that technical analysis is more art than science, although we are seeking to increase the reliability and consistency of this method by the use of technical indicators, rather than just by “feel or hunch”.

Using a standard three month daily chart, we begin by looking for stocks that can be identified as now being “overbought” on a short to intermediate term basis, yet are beginning to show signs of weakening. This reduces the risk for our shorting entry point. Although stocks can remain “overbought” for a long period of time, the risk of a huge run up is smaller than for stocks with technical indicators that have recently improved from oversold to neutral ranges.

On a daily chart, we can identify “overbought” through indicators such as Relative Strength (RSI), and Stochastics. The RSI (14) would be above 70, and the Stochastics (14, 1) above 80. Then we look for conditions which may signal or confirm a reversal of the trend. While it may not be necessary to have all of these conditions present, the more that are present, the better the results tend to be:

1) Declining volume on the last up day or days

2) A recent negative divergence between stock price and RSI (14) or MACD, in which the stock price increases, while the indicator declines

3) A candlestick reversal pattern such as a “Doji” or “Hanging Man”, and/or a negative technical pattern unfolding, such as a double top or head and shoulders top formation.

4) A very recent decline below 70 on the RSI(14) along with a decline in the Stochastics(14,1) below 80, and the shorter moving average crossing below the longer moving average on the MACD.

5) Decreasing upside volume on the 1 minute and 5 minute bars just prior to the trade.

Overbought stocks can be readily found through www.stockcharts.com. Stockcharts has a predefined scan for stocks with various technical indicators on a daily chart. The link is: http://stockcharts.com/def/servlet/SC.scan

Overbought stocks can also be found at the following web sites:

http://tickersense.typepad.com/ticker_sense/2006/02/overbought_over.html

http://www.thegreedytrader.com/StochasticOscillator.aspx

Ironically, many potential shorts can be found by consulting the lists of strongest stocks on Investors Business Daily. Because these stocks have been so strong for quite awhile, many of them are at or soon to be at overbought levels. By checking these stocks and their charts on a daily basis, one can see when they are beginning to show the signs of weakening that will signal a reversal in trend.

Sometimes the stocks are just too hot to cool off. The best plays are when there is no significant news for the stock that day, and the advancement at the opening is just non-institutional, i.e. individual investor money flowing in, often after the previous day’s news or comments from a popular media source, and at the top of the uptrend. Significant good news makes shorting success very difficult. Trying to catch the top of the early move on a stock with a good earnings report or analyst upgrade is a recipe for disaster. The stock usually retraces just a small part of the move before advancing higher, and one gets stopped out quickly with a loss. Therefore, we do not recommend shorting stocks on the same day that significant good news has been announced.

Checking to see how many block trades have been made in the opening minutes can confirm who the buyers are. A stock showing no block trades will work best for shorting, as it is more likely that buyers are individual, rather than institutional in nature. We never want to try to buck the trend when institutions are buying shares. In fact, high volume of any type may be problematic, as it is often representative of some strong controlling force influencing market events.

Once we have found our shorting candidate, we place it on the portfolio list of our trading platform. Then we track the movements of price, volume, and technical indicators from the market opening.

Ideally the overbought stock will show a decent run up from the market opening, often as much as 2-3% advancement from the previous day’s closing price. When this occurs we now have an intraday extended position, along with an overbought stock on the three month daily chart, which substantially reduces our risk for further price advance, and maximizes our profit potential.

Using the intraday chart, we wait until we see an overbought condition, with the one minute interval chart showing RSI (14) above 70 and Stochastics (14,1) at or near 100. Another criteria to watch for is price “congestion”, with the stock floundering below the most recent high, either unable to penetrate that high, or at best making one new high of less than 1%, followed by a small retracement, and then the inability to climb back to the new high. This demonstrates a strong degree of short term resistance at that level, and further increases the likelihood that a significant downward move will soon begin.

We already have the trading platform open, with stock symbol, type of trade (sell short), number of shares, and market order already in place, so we are ready to trade with just one more quick click of the mouse. The aggressive tendency would be to short the stock from the overbought levels, and simply wait and anticipate the trend reversal. While this approach may sometimes improve the profit margin, it could also be a mistake, as the stock may not decline from the overbought position for some time, and would frequently continue to run up in price. We do not recommend this approach for those reasons.

The more prudent method we employ is to wait until the indicators begin to fall from overbought levels, such as RSI (14) moving from 73 to 68, before entering the order to short the stock. This slightly reduces our potential reward, but also considerably reduces our risk of loss. Preservation of capital should always outweigh the desire for enhanced profit in trading decisions.

We have noticed that many stocks seem to peak around 9:45 AM to 10:15 AM. It is then common for them to pull back, and often in three “legs” down, which may take an hour or more. Our objective is to short the stock as close to the top peak as possible, and then ride the price down through these legs thereafter. When we feel that either the stock has bottomed, or our price objective has been reached, we will then cover our short, and exit the position for a profit.

Covering the Short Position

One should place either a stop loss or a stop limit order about 10-15 cents above the previous intra-day high. Which stop order to use is a matter of personal preference. For a good explanation of the difference between stop loss or stop limit, see the following link:

http://beginnersinvest.about.com/od/investing101/ss/stocktrading_5.htm

If we are fairly close to the previous high, and strongly believe that the stock is beginning to weaken, we risk very little if the price does move higher. The previous high usually acts as short term resistance to higher prices, so the odds are in our favor on the short side of the trade. However, the danger is in the stock taking out the previous high by just a little bit, having our cover position filled prematurely, followed by a reversal to the downside.

At those times, we may fault ourselves for placing such a tight stop order. But that risk outweighs placing the stop order too far away from the last price peak, and losing even more money if the stock trades against us. Placing the stop order 10-15 cents above the previous high prevents us from having the position covered by a premature break out of just a few cents. Usually if a stock can rise 10-15 cents beyond the previous high, that signifies a continuing bullish pattern. Of course, 10-15 cents assumes the stock price is not $5 or $6, which would represent a 2%+ move. In such cases, the stop order can be placed 7-10 cents above the previous high. For higher priced stocks, such as $100, one might have to adjust the stop price higher, perhaps to 25-50 cents above the last peak.

Once we have placed our order and the stock price starts to decline, perhaps even below the 20 minute simple moving average (SMA), we begin tracking the decline of the RSI and Stochastics as well. Once the price falls below the 100 minute SMA, the odds of a profitable trade will increase substantially. The 100 minute SMA is much more reliable in establishing resistance than is the 20 minute, but by waiting for the decline below the 100 minute SMA, one will capture much less of the move. Sometimes the first penetration below the 100 minute SMA is a false breakout. There is a small retracement higher, then a second break through below the 100 minute SMA, resulting in a rapid sell off in the stock, as traders see that the 100 minute SMA will not hold.

Replacement of the Previous Limit Order

As the stock declines, you can now lock in your profit by canceling the first stop order, which was the stop loss above the entry point, and replacing it, or by closing out the position with a market order once the decline in price seems to have run its course.

There are of course, advantages and disadvantages to each decision. If you move the stop order too low, you could sabotage your profit on a quick counter trend bounce. If you replace the stop with a market order, you may close out a winning position prematurely. Our best advice is to lower the stop enough to guarantee a profit, yet far enough above the current price to avoid being stopped out prematurely. To do this, we recommend leaving the stop order at its original height until a new intraday high appears on one of the legs down. Each time that a new leg down is created, a stop can usually be placed 10-15 cents above the latest, lower high. Should that high be taken out, it usually indicates a bullish reversal taking place, and one may want to take profits on their short position under such conditions.

The determination on whether or not to cover at market is an individual one, but one which should be based upon the technical indicators, action of the stock at hand, and the monetary goals of the trader.

EXITING THE POSITION

A short position may be terminated by either buying to cover the shares at market price, or with a buy to cover limit order. Exiting on a market order gives you more control over where you take your profit, while exiting with a limit order could increase the potential for a greater profit, depending on what price is set. This decision must be left up to each individual. A more systemized exit, such as two white candle-sticks in a row, a Doji, or a Hammer pattern might help to close out the position at the best time. For more information on candlestick patterns, please see the link below:

http://www.candlestickforum.com/PPF/Parameters/12_76_/candlestick.asp

The most conservative approach is to exit the short position when the RSI(14) drops to between 30-40, and the Stochastics(14,1) are in the 20-30 range on the one minute intraday chart. However, results will generally improve, though with slightly more risk of upside reversal, by waiting until the Stochastics drop to single digits or even zero, and the RSI is at 30 or below.

The tendency is for Stochastic (14, 1) readings to rise or decline much more quickly than the RSI(14) does. Stochastics may drop to zero and climb back to 80 or better several times during the same time that it takes the RSI to move from 70 to 30. Each time that the Stochastic hits zero or single digits, it is likely to bounce back up, and the stock will rebound. However, the 20 period SMA on the five minute bar chart (100 minutes SMA) should act as resistance, with the stock declining again each time it touches or nearly touches the moving average line. Patience is important. If one is impatient, and takes profits simply because the Stochastic is oversold, but without the RSI also being oversold, the profits missed could be significant.

Often the stock will break above the 20 minute SMA on the 1 minute interval, but the 100 minute SMA will act as resistance. Should the stock break above the 100 minute SMA line, the trader should be ready to close out the short position. Although occasionally there are false breakouts, more often the penetration of the 100 minute SMA marks the end of the stock price decline, and the beginning of a new bullish trend. By waiting too long, the trader may risk giving back a significant portion of their profits.
Example of Our Preferred Chart Pattern:

The following is a three month daily chart of Rangold Resources Limited (GOLD). This is typical of the type of stock chart we would choose, in our search for a suitable stock to short. Notice the recent over extension to overbought territory on January 14th, followed by the RSI decline from 79 that day, to 67 (neutral) by January 15th. Also notice the simultaneous breaking down of the Stochastic from an extremely overbought level of 99 to 73. This was indicative of a weakening position. Subsequently, there was a $2.17 drop in price on January 15th, from the peak to the low, about a 4.5% decline overall.

10 days later, the chart was once again overbought, with RSI at 72, and Stochastics at 97. Once again, there was a significant decline in price over the next two days, from a high of 49.07 to a low of 46.06.

 

RECENT RESULTS

We would like to present some recent results which utilized this method. From our last ten trades since January 7th, this method has produced eight winning trades and two losing ones. (See chart below)

The losing trades were minimal, and for substantially less money than the winners. Limiting the losses with tight stop limits, while letting the winners ride, kept our positions in a profitable state. Although it is frustrating to be stopped out, it is one of the best ways to reduce the risk involved in the shorting process.

Total round trip trades= 10
Total pre-tax gain= $1948.89 (2,031.78 – 82.89)
Commission cost = $160
Pre-tax profit = $1,788.89

While the number of shares traded was most often the same, the dollar amounts of the trades would vary slightly. Keeping the dollar amount the same on all trades would have necessitated odd lot trades and may have impeded the price at which we were able to enter and exit the trades.

The percentage of profitable trades was 80%. The largest profitable trade was $600, the lowest $100.00, and the average of the eight profitable trades was $253.97. The largest losing trade was $59.97 and the smallest $22.92. The average losing trade was $41.44. So this method produced a reward to risk ratio of 6.1 to 1. With a ratio like that, even a much lower percentage of winning trades would have still produced a profitable method. The average percentage of the winning trades was 1.57 %, while the average percentage of the losing trades was only .0045 %. The overall average was 1.26% per trade.

These results were produced over six trading days. Although 1.26% doesn’t sound like much, if we assume approximately 20 trading days per month, over a 12 month period that is 240 trading days. If we assume 1 trade per day then this strategy would present returns of 302% in a single year.

On an original investment of say, $25,000, after one year the trader would have approximately $100 500.00 (pre-tax figures).

SUMMARY

We have attempted to produce a low risk/high potential reward method of shorting stocks. We first identify stocks which are declining from overbought positions, then look for situations of the highest probable profit by shorting only those stocks with early morning advances that leave the stocks overextended and vulnerable to a large pull back in price. We measure this vulnerability with several different technical indicators, such as RSI declining below 70 and Stochastics declining below 80 for confirmation. We may also utilize other indications of a peak in price, such as diminishing volume on the upside, congestion at a recent high, and a negative turn to the overall market.

When we are confident that our entry point is sufficiently low risk/high reward, we enter a short position with a market order. Immediately thereafter, we enter a stop loss or stop limit order approximately 10-15 cents above the most recent high. If our decision is correct, the profit potential is great. If our decision is incorrect, we will lose only a small amount of money per trade.

Our goal is twofold:

1. To produce a high percentage of winning trades to losing trades
2. For the average amount of money gained in any winning trade to be far greater than the money lost in the average losing trade.

As the trade moves in our favor (ie stock declines in price), we can adjust our stop orders to 10-15 cents above each new down leg, so as to guarantee a profit on each trade, no matter what the stock does from there. Another possible exit point is 10-15 cents above the five minute Simple Moving Average.

We determine the best exit position by utilizing the same two indicators in reverse, and by using market or limit orders to cover the short position. We have had great success in covering on the same day when the RSI becomes oversold below 30, and begins to move up from that level, and the stochastics are oversold below 20 and begin to move up from that level.

Some recent examples of short term trades that employed this method were provided.

As this is a method, and not a rigid system, the reader is free to experiment with different variations, such as the use of other technical indicators, expanding the length of time of the short position, or changing the placement of the stop orders. Despite our incredible success, and careful analysis of the method presented, trading involves quick timing, emotional responses, and human decision making. Therefore, the results achieved by other traders can not be guaranteed to be the same, and could be better or worse than our results.

Further Studies

We could consider the use of the Parabolic SAR to indentify overbought stocks. We could also examine the use of a MACD crossover to time the entry of the trade. We would also like to see if shorting works better or worse with stocks that are in a downtrend, trading sideways, are highly volatile, or have low historical volatility with a big recent price movement. As always the risks and potential rewards must be weighed together when analyzing the results.