I recently read a great book on market psychology called Market Mind Games by Denise Shull. What struck me was a small paragraph concerning down-trending markets. To paraphrase a bit, why can’t most traders be just as profitable in a down trend as an uptrend? It makes no sense at all. It’s illogical at best. I must agree.
While investors are ALWAYS long and looking for higher highs, traders can get alpha in both directions. It’s a huge advantage. The late great trader Jesse Livermore made the great majority of his money shorting the market, and many others have as well. Most traders focus on buying low and selling high, but there is also money to be made by selling high and buying low. This is known as short selling, and it involves borrowing shares of a stock and selling them at the current price, with the hope of buying them back later at a lower price and returning them to the lender. Option traders can buy puts to place the same bet.
The big risk of short selling is being in a position and the market screams higher. That would equal the so-called unlimited loss scenario, although I have yet to see a stock at the infinity price. Buying Put options allows you to go short for a defined amount, the premium paid for the option. Despite the risks, short selling can be a very profitable strategy for trading markets down.
EMOTIONS
All the same risks apply to trading on the downtrend. Greed and fear do not go away magically. The same emotional swings in trader sentiment accompany the spiral downward, often at an accentuated pace. You have all heard markets go up on an escalator and down on an elevator.
One of the biggest challenges that traders face when trading markets down is the fear of loss. The fear of loss is a very powerful emotion, and it can lead traders to make irrational decisions. For example, a trader who is scared of losing money may hold onto a losing short position longer than they should, in the hope that the market will eventually turn south. However, this can often lead to even bigger losses as the market climbs higher.
It is important to remember that losses are an inevitable part of trading. No trader wins all the time. The key is to manage your losses effectively so that they do not wipe out your account.
It is also important to have a good understanding of the technical and fundamental factors that drive market downtrends. This will help you to identify stocks that are likely to continue to decline and to avoid stocks that are likely to rebound. So, what should you look for to get short a stock?
A TOPPING MARKET
When everyone has already bought the stock who wants it, the buyers get exhausted. The birds of prey are circling above.
Often the best stock to short are overbought positions. Technical analysis is the study of historical price charts and technical indicators in order to predict future price movements. Technical analysis can be a very helpful tool for short sellers, as it can help them to identify potential trading opportunities and to manage their risk.
Technical indicators like the Relative Strength Index (RSI)and the Percentage Price Oscillator (PPO) can all quickly point out price divergences from momentum. The Commodity Channel Index (CCI) shows overbought levels. These are sometimes great indicators to short sell or but puts.
A DECLINING MARKET
Like a flag thrown in football for piling on a down player, this is the most common time to get short. It’s legal piling on!
- Do your research. Before you short sell any stock, it is important to do your research and understand the company’s fundamentals. This will help you to identify stocks that are likely to continue to decline. Declining revenue, margins and increased expenses look great to a short seller.
- Focus on short selling stocks that are showing signs of weakness. This includes stocks that are making new lows, breaking below key support levels, and experiencing high volume selling.
- Look for stocks that are weaker relative to their peers in the same sector or industry.
Trading a market down can be a risky strategy, but it can also be very profitable in a short amount of time. By identifying a topping market or a down and out stock that you can legally pile on, you can increase your chances of success. And that is where the profits are!
Enuf said.