The second in a multi-part series of short-selling by Gil Morales and edits by Dr. Chris Kacher. Mr. Morales achieved roughly triple digit percentage gains at times such as in 2001 and in the flash crash of 2010. He wrote the book on short selling twice, once with William O'Neil then again in an updated version using daily charts with Dr. Chris Kacher.
Part 2 – The Six Essential Rules of Short-Selling
By Gil Morales, Managing Director
MoKa Investors, LLC
Short-selling is a complex matter. The techniques are fluid and dynamic, and one must have a certain obsessive personality when it comes to having the persistence to succeed at the short side of the market. We can start, however, by breaking it down into its manageable components. These components comprise the Six Essential Rules of Short-Selling. Let us begin at the beginning.
Rule #1: Know where you are in the cycle.
In the past, both I and Bill O’Neil stipulated that short-selling should only be undertaken during a bear market, and as close to the start of the bear market as possible. In hindsight and after gaining much more experience as a short-seller I can safely say that this is woefully simplistic. Today I would refine this to a more essential and slightly broader concept of understanding where one is in the bear cycle as well as understanding whether one is in fact sitting at the precipice of a longer-term bear market or just a less severe and normal market correction during an overall bull market.
Having a basic grasp of how bear markets unfold and applying that to the timing of one’s short-sale operations can help one to more effectively exploit the most optimal points during the bear market at which to sell short and remain short. Obviously, one does not want to start shorting stocks after the market has been in a bear phase for a while, and the selling has become obvious to just about everyone since the risk of a major new rally starting increases as the bear market wears on.
Bear markets, however, do not come in a handy-dandy one-size-fits-all form. They can vary greatly with respect to duration, downside velocity, and total percentage decline. In addition, the way they unfold is dependent to a reasonable degree on the context of the current economic and political backdrops. Sometimes they aren’t even bear markets at all. Normal market corrections of 7-12% during an overall bull market cycle can offer decent opportunities on the short side.
We also observe that some of the leaders in each cycle top and fall by the wayside as part of the normal rotation that occurs in a longer-term bull cycle as new groups rise up to carry the bull market banner as old ones correct or outright top. For example, during the bull market cycle of 2003-2007 housing stocks and financials, both leaders during that cycle, topped well before the final top in October 2007. Often, these tops will coincide with shorter-term market corrections of 7-12%.
Understanding how bear markets and short corrections unfold can help in the timing of one’s short-selling operations. Shorting late in the cycle, or at a point where even a short-term correction might be reaching a short-term terminus, carries greater risk than shorting earlier in the movement, whether it is a short-term or longer-term movement.
Often, longer-term bear movements consist of many smaller movements, or “legs.” Understanding where the movement is in terms of these “legs” is helpful in the short-sale timing process. Understanding where a short-term correction might be coming to a terminus as it undercuts, for example, prior lows in the indexes’ chart patterns, also aids in the timing of short-sales, as well as the timing of when to take short-sale profits.
In this way, the “macro” helps to guide the “micro,” the point at which actual short-sale positions are taken and the points at which profits are taken. Short-selling is like a dance, where you must follow your partner, the market, as it dips and dives across the floor. Knowing where you are on the dance floor is critical for successful short-selling. Stay tuned for part 2.
Risk ManagementIn the meantime, always know that risk management is the most important rule when it comes to investing. If your average reward:risk is 3:1, you can lose 3 times for every win to breakeven. When it comes to going long stock, our Wyckoff undercut & rally entry points discussed here keep risk to a minimum, typically less than 2%. Meanwhile, the gains in leading stocks of which our Focus List is mostly comprised are typically high single to low double digit percentages as stocks often slingshot back after a brief period of market weakness, thus the average reward:risk can far surpass 3:1 using this buying strategy. Further, using any of our buying strategies as shown in our reports section can yield a couple strong wins in the stocks where you're able to sit in the position for a number of weeks or longer. Such recent examples include SQ, BZUN, BABA, and/or AAOI and can make all the difference to your account.