Shorting Stocks - The Basics, Part II of II

After the publication of the first part of this two part series, I had a few questions asking if shorting stocks is legal and I will quickly reply with a big YES. Some people believe that shorting shares of American companies is not patriotic or does not seem like the right thing to do. Shorting stocks is not my primary method of making profits in the market as many of you already know, but it is a valid strategy that must be covered especially since the market has focused on red flag and shorting opportunities since December 2004. In the world of supply and demand, things go up and things go down, it's human nature. Stocks have been shorted for over a century and have provided investors with an alternative strategy to making profits.

To initiate a short sale, you must place the order with your broker or online brokerage by determining the size and price at which the trade will occur. Your broker or brokerage company will check to see if shares are available in the specific stock selected or if they can borrow the shares. Once they are available or can be borrowed, they will be sold in the open market on the first plus tick or continuation of an up-tick also known as zero-plus tick (the stock must move up for the transaction to complete). To close the short position, the broker will purchase the shares using the original proceeds and return the shares to the third party.

As a short seller, you believe that the price of a particular stock will fall in value over time. For example: by establishing a short position for 100 shares in XYZ at $50, the broker will place $5,000 into your margin account. If the stocks falls over the next few weeks and you decide to cover the short at $40, you will initiate a buy for 100 shares in XYZ using the money placed in your account when you sold short. The cost to buy back the shares in this example will be $4,000 or $1,000 less than the original short sale amount. This difference in price will result in $1000 cash that will now become your profit.

On the flip side, if the stock was to jump to $60, you would most likely cover your short or have your stop loss triggered, buying back the shares at this price. The cost would be $6000 or $1000 more than the original short sale, resulting in a 20% loss. The broker would take the additional $1000 from your cash account to cover the loss in the short sale. This is how you can lose money when shorting stocks. The higher the stocks rises, the more money you can lose, theoretically resulting with an infinite loss (excluding stop losses and broker margin calls).

If the stock rises in price or if the value of the stocks you are using as collateral goes down in price, you may be forced to add cash to your margin account or cover the short sale prematurely. As I mentioned in the first article, you must pay any dividends issued while you are short a particular stock.

The two basic reasons for selling short would be to profit from a stock that you believe is grossly overvalued or to hedge your account with protection from a down-swing in prices due to anticipated or unexpected events. In the first case, you may have noticed a stock such as EBAY (red flag on our screens since December) topping on the charts and then slicing through all long term trend lines in above average volume. If the stock fails to recover these key trend lines, a further decline may be in the immediate future and you may want to profit from this action. In the second case, you may own several stocks and fear a market downturn is on the horizon but don't want to sell for certain reasons. Instead, the investor can short specific stocks to hedge their account against possible down-turns. Some investors diversify their portfolio with several long positions and a few short positions. I don't agree with this strategy but it is a common practice by some institutions and investors.

All short positions should be covered if earnings and sales surprise the street or are starting to become positive. A short should be covered when it breaks above the 200-d moving average and certainly covered when it breaks above the 50-d moving average. If the relative strength line starts to move up, gradually making its way to new territory, I would advise covering the short position before a big breakout occurs. If the 'M' in CANSLIM is starting to turn positive and the daily new highs list if growing with new leaders, this would be a clue that a new up-trend if on the way or currently forming, alerting you that it may be time to cover the short positions before they turn negative.

Some investors may become impatient during bear markets or sideways markets if they don't learn how to short stocks. Shorting stocks will contribute to a more consistent strategy throughout good and bad times. As I have said in previous articles, shorting is not for everyone and nothing is wrong with sitting in cash during bear markets, awaiting the next breakout and fresh batch of leaders.

Most important, always cut your losses quick! This rule applies to any strategy in the stock market.

Chris Perruna - http://www.marketstockwatch.com

Chris is the Founder and President of MarketStockWatch.com, an internet community that teaches you how to invest your money with solid rules. We don't stop at just showing you our daily and weekly screens, we teach you how to make your own screens through education. Through our philosophy, you will be able to create your own methods and styles to become successful.