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Market Lab Report - Part 4: The Six Essential Rules of Short-Selling (or for those who dont short, how to identify prone patterns for a safe exit)

Part 4 – The Six Essential Rules of Short-Selling

By Gil Morales, Managing Director, MoKa Investors, LLC

Timing and liquidity are critical issues for short-selling. However, the next two rules which pertain to these have evolved and changed since I first co-authored the book How to Make Money Selling Stocks Short with Bill O’Neil. Over time I have found that there is some flexibility with respect to both timing and liquidity. In the process of gaining more experience and knowledge on the short-side over my 26-year career, these two rules have been revised somewhat.

Rule #3: Seek to short former, big-stock leaders 8-12 weeks after their peak price following a major upside price run, except when dealing with potential late-stage breakout failures that lead to immediate Late-Stage Failed-Base (LSFB) short-sale set-ups.

By definition, major topping formations like the Head & Shoulders (H&S) top will take 8-12 weeks or more from the absolute peak to finish developing and fully complete the right shoulder area of the pattern before resulting in a sharp downside “breakout” that takes the stock much lower. But there are set-ups that provide for earlier entries on the short side of a breaking or broken down leader close to the peaks.

When I first began studying the short side of the market, I noticed, however, that in an H&S pattern the initial break off the peak that formed the right side of the “head” in the overall formation would often occur as the result of a late-stage base breakout failure of some sort. I noticed that in most cases, such a price break, whether it in fact formed the right side of a head in an overall H&S pattern or not, was very steep. Capturing this price break on the short side, I observed, would be very profitable. And so, the “Late-Stage Failed-Base” (LSFB) short-sale set-up was born, and was first formally discussed revealed in our book, Trade Like an O’Neil Disciple (Wiley, 2010).

By definition, the LSFB set-up can present a short-sale entry within days after a leading stock’s peak price occurs. That can then evolve into an H&S top, which can then take another 8-12 weeks or longer to form. In this way, an LSFB allows for shorting a stock earlier in its initial breakdown, constituting the first down “leg.” Many times the second leg of a stock’s overall breakdown and distributive downtrend will commence with a break below the “neckline” of an H&S pattern that forms after the LSFB.

But being able to identify and short a stock on the basis of an LSFB helps us to get in early, on the first down leg of a leading stock’s breakdown and eventual longer-term downtrend. Think of it as a “first-mover” advantage short-sale set-up.

In most cases the biggest breakdowns will, however, occur on the second or third legs in an overall downtrend in a former big leader. Those are always at least 8-12 weeks after the peak, and there is a good reason for their increased downside velocity. Bullish sentiment in a big-stock leader will remain persistent for a decent period of time after the peak.

Those who missed the big price run will initially see the break off the peak as a “buying opportunity,” and this perception by late bulls may persist for a while until all of the bullish sentiment is literally wrung out of the stock. Eventually, the bottom-fishers and bargain-hunters become “trapped” longs, and their panic selling helps to drive the stock even lower. Sometimes this can occur in parabolic fashion.

The bottom line is that stocks can be shorted at any point in their overall breakdowns and downtrends, depending on which short-sale set-up the stock is forming. Sometimes they can be shorted near the peak, sometimes not. Sometimes they can be shorted initially on an LSFB set-up, and then later on, shorted again on an H&S set-up as the LSFB eventually evolves into an H&S. So, in conclusion, the general rule of waiting 8-12 weeks after a stock peaks is not relevant in all cases, depending on the exact set-up one is using.

Rule #4: Only sell short stocks that trade a minimum of 1-2 million shares a day, and preferably more. In general, avoid thinly-traded stocks as short-sale candidates, as risk can correlate inversely to a stock’s trading liquidity.

In most cases, big-stock leaders will be highly liquid traders with average daily volume well in excess of 1-2 million shares. I prefer to short stocks that trade more than 2-5 million shares or more a day on average. The more liquid they are, the better, for some very simple reasons. The first is that the bigger any big-stock leader is, the more volume it will trade, and the second is that the more liquid the stock is, the easier it is to move in and out of quickly.

Those operating with much smaller account sizes, say $100,000 or less, can, however, deal in thinner stocks on the short side. Because a smaller account does not need so many shares to fulfill a 10-30% allocation, thinner stocks don’t necessarily present a problem with respect to position size. However, keep in mind that thinner stocks can tend to carry more risk simply by the fact that their thin trade makes them vulnerable to more volatile upside price moves.

In general, the “thicker” a stock is in terms of its average daily volume, the better, regardless of your account size and its associated position size requirements.

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.

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This information is provided by MoKa Investors, LLC DBA Virtue of Selfish Investing (VoSI) is issued solely for informational purposes and does not constitute an offer to sell or a solicitation of an offer to buy securities. Information contained herein is based on sources which we believe to be reliable but is not guaranteed by us as being accurate and does not purport to be a complete statement or summary of available data. VoSI reports are intended to alert VoSI members to technical developments in certain securities that may or may not be actionable, only, and are not intended as recommendations. Past performance is not a guarantee, nor is it necessarily indicative, of future results. Opinions expressed herein are statements of our judgment as of the publication date and are subject to change without notice. Entities including but not limited to VoSI, its members, officers, directors, employees, customers, agents, and affiliates may have a position, long or short, in the securities referred to herein, and/or other related securities, and may increase or decrease such position or take a contra position. Additional information is available upon written request. This publication is for clients of Virtue of Selfish Investing. Reproduction without written permission is strictly prohibited and will be prosecuted to the full extent of the law. ©2024 MoKa Investors, LLC DBA Virtue of Selfish Investing. All rights reserved.
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