Ten Roadblocks To Profitable Short Selling

[Leth]

Ten Roadblocks To Profitable Short Selling
By HRE


Short-selling has come back into vogue in recent months, with the major averages convulsing in response to the mortgage crisis. In fact, we've seen more downside pressure this year than at any time since the 2000-to-2002 bear market. This decline has forced a cadre of long-only traders and investors to revisit this classic strategy.

But short-selling's popularity can be a contrary signal, because bad things will happen when that side of the market gets overcrowded. This is especially true after amateur shorts apply the same methods they use in their stockpicking, but in reverse. In other words, they chase downward momentum without an understanding of the considerable risk.

Despite the threat of unexpected squeezes, short-selling could be the hottest game in town in 2008. Just keep in mind that it's still not easy to make money selling first and buying later. In fact, most readers will stare at falling prices for hours, and then enter their sales at exactly the wrong time. This is one of the great truths of this trading methodology.

I've compiled 10 of the most common roadblocks to profitable short-selling. Review the list and understand why this practice can cause so much pain and suffering, when misapplied. Also, remember that a downtrend makes short-selling even tougher at times, because it's harder to find your edge against other traders playing the same game.

1. Dull Markets: Even falling stocks and indices show tremendous overlap for long periods of time. Mark out the boundaries of the high and low on today's price bar. Most instruments will trade through a good portion of that range in tomorrow's session. This is a problem for short-selling, because it screws up stop placement.

2. 80/20 Rule: Markets just spin their wheels most of the time, even in downtrends, and nasty selloffs tend to happen quickly and in sudden bursts. So short-sellers must exercise extreme patience while they lie in wait for a seller's market, or risk getting burned because their timing isn't absolutely perfect.

3. Grazing With the Herd: Short-selling makes a terrible group sport. The majority of popular stocks in obvious declines, like the homebuilders these days, carry high short interest and attract endless squeezes that lift price just a few cents beyond your emotional tolerance.

4. Bad Analysis: Support/resistance is a multifaceted, three-dimensional animal in this machine-driven market. That means price movement often carves through highs, lows, trendlines and moving averages, without regard for classic technical analysis. That's why you'll be shorting into oversold rallies that go up, up and up ... until you can't stand it anymore.

5. Emotional Baggage: Your emotions will do a back-flip as soon as you enter a new short position. Your stomach twists and turns with every uptick, while you question your position choice and sanity. This act of torture is even worse than watching a long position take a dive. Apparently, the forces of gravity let us cope with those events a whole lot better.

6. Chasing the Tape: It's often too late to sell short by the time you see a nose dive gather momentum. It's just a question of market mechanics. Traders who sold short from higher levels are looking to cover at the same time you get excited and enter your position. Even worse, those folks add considerable buying power as they take profits. That's why you'll be selling the bottom with shocking regularity.

7. Kass-o-phobia: It could be the end of the world, but what does the chart look like? You might be waking up in a cold sweat worried about financial Armageddon, but you're going to lose money if the charts don't agree with you. And you can't make a single dime selling your fears short. You need a stock to do that.

8. Bear Traps: That cheese sure looks appetizing, but did you notice the spring-loaded mousetrap? The most obvious short-selling patterns are obvious to everyone else as well. That's why they tend to trigger the most violent squeezes. The best shorts come from the less noticed spots on the charts, like just after a stock jumps above resistance.

9. Trend Relativity Errors: This is a really bad market, right? Well maybe not, because the major indices just hit new highs last month. This denotes a relative balance of buying and selling power, rather than a lopsided environment in which everyone is looking to get out of the exit door at the same time.

10. Calendars and Seasonality: Short-sales work best when Wall Street isn't painting the tape. Options expiration, window-dressing, and tax selling periods all undermine normal market flow and practically ensure your carefully chosen short-sale won't make a dime.