Part 3 – The Six Essential Rules of Short-Selling
By Gil Morales, Managing Director, MoKa Investors, LLC
Rule #1, which was discussed in the last article of this series, focused on the general market and the phases of a bear market or correction. The next rule focuses on the stocks that serve as short-sale targets during market downturns.
Rule #2: Focus on those “big stock” leaders that had huge upside price moves in the immediately preceding bull market phase and that are showing significant signs of topping.
A question I am frequently asked is how one creates a short-sale watch list. The answer is actually quite simple. There is no need to screen for short-sale candidates, because for the most part they will come right off your long watch list that you built during the prior market uptrend. Usually these will be big-stock leaders that institutions have been buying hand over fist during a bull market.
A big-stock, as I define it, is a stock that is on the cutting edge of developments driving any particular economic, and hence market, cycle. Knowing which stocks these are means knowing where institutional investors “have to be” with respect to positioning their portfolios. When institutional investors start shoveling money into stocks in which their portfolios must have representation, this fuels tremendous upside price moves in those stocks. It is, in fact, what makes them ‘Big Stocks.’” In Jesse Livermore’s day, he referred to them as “the leading issues of the day.”
While the Big-Stock Principle, as I call it, is usually applied to the long side of a bull market, it is also equally relevant to the short side during a market correction or full-blown bear market. Big, leading stocks run up in price over many weeks, months, or years as institutions pile in and push them up with their enormous buying power. But eventually every institution and every investor that can buy the stock already has bought it as it gets “loaded up” on it, and the “accumulation” phase is over. At that point the only direction for the money to start flowing is out of the stock as the “distribution” phase begins. This is when leading stocks top, and when they begin to break down the magnitude and rapidity of the ensuing downside, trends can be very profitable for the short-seller.
One way to assess when a big-stock leader might be moving into a distribution phase is to track institutional sponsorship in the stock. From my experience advising institutional investors (which I did at William O’Neil + Co., Inc. from 1997 to 2005 as manager of the institutional services group there), most begin accumulating a position in a stock with the idea of holding it for 3-5 years. Sometimes certain institutional investors become what is often called the “axe” in a particular big stock as they continuously buy the stock, making it an ever larger position in their portfolio as the stock continues to rise.
Another aspect of big, leading stocks is that during their uptrends they tend to benefit from very large price-to-earnings, or “P/E” ratio expansions. Leading stocks can sell for 30-40 times earnings or more at the time that they begin their price runs, and their P/E ratios can expand to more than double or triple that (sometimes even more!) through the course of their upside trends. When the stock finally tops, the P/E ratio can deflate very quickly, particularly in an all-out bear market, and this can drive the stock down in a consistent and sometimes accelerating rate.
Examples of current big stock leaders (some of which have topped and broken apart over the past year or so) would include Apple (AAPL), Amaxon.com (AMZN), Alibaba (BABA), Ambarella (AMBA), Applied Optoelectronics (AAOI), Facebook (FB), Alphabet (GOOGL), GoPro (GPRO), Netflix (NFLX), Nvidia (NVDA), Tesla (TSLA), Weibo (WB), etc. One major point: do not confuse the term “big stock” for “big-cap.” While some big-stock leaders can have very large market capitalizations, such as, for example, Amazon.com (AMZN) orFacebook (FB), that is merely incidental to their “big stock” status. Small-cap and mid-cap stocks can also be “big stocks” if they meet the definition as dictated by the Big Stock Principle, such as names like Ambarella (AMBA) and Applied Optoelectronics (AAOI).
Focusing on the big-stock leaders from the prior bull cycle also simplifies the process of building a short-sale watch list. If stock is on your buy watch list and starts showing heavy-volume selling off the peak after a long price run, you can move them to a short-selling watch list. All the short-selling chart pattern set-ups that we use, such as the head and shoulders (H&S) and its corollary, the late-stage failed-base (LSFB), rely on a high-volume break off of the peak. This is often the first sign of institutional money exiting a stock en masse as they begin “distributing” stock.
This high-volume price break often will define the right side of the “head” in a head and shoulders topping formation or a new base breakout that fails as the stock reverses back into its prior base on heavy selling volume, as we will see when we discuss short-selling set-ups. Once a big-stock leader breaks sharply off its peak on heavy volume the stock is then monitored in order to determine whether it is in fact in the process of shaping and then completing an overall topping pattern.
Portions of this article have been excerpted from “Short-Selling with the O’Neil Disciples: Turn to the Dark Side of Trading” by Gil Morales & Chris Kacher published by John Wiley & Sons in April 2014.