This week’s Trading Lesson
Here is an excerpt from my upcoming book, The Mindless Investor, How to Make Money in the Market by Overcoming Your Common Sense. This piece is from the chapter, Price Direction Does Not Matter:
Most traders focus on buying stocks with an expectation that the price will rise. It is less common to try and make money from stocks going down. It is also possible to make money from price decline and, since markets often go down as well as up, it makes sense to be willing to do so.
Short selling is how you make money from a stock’s decline. When you short, you still buy and sell the stock, you just do so in reverse order. Sell first and then buy back later. But how do you sell something you don’t own?
The answer is to borrow the shares that you think are going to go lower. The brokerage you deal with has a great many customers. Between all of those investors, there are a large number of shares being held in many different companies. A person you have never met may have the shares of the stock that you think is going to go lower and, like a bank that lends out the money from its depositors, your broker is going to let you borrow someone else’s shares to sell.
Eventually you will have to return the shares you borrowed. Hopefully, the price will fall as you predict so that you can buy them back at a lower price. In this scenario, you have bought at a lower price than you sold them, netting the difference as profit.
You borrow the shares and sell them in the market. With the sale, you get an injection of cash into your account, a pretty good deal considering you didn’t even own the shares you sold. Sadly, it’s not that easy to grow your capital base. Your broker requires that you have sufficient capital to buy back the borrowed shares, so that they can return them to the person who owned them in the first place. The brokerage is not going to take a risk on your trade, so you must always maintain 150% of the value of the shares you sold so that you have enough capital to buy them back if necessary. The sale of the shares gives you 100%, but you have to add in another 50% and maintain that 150% of whatever the borrowed position is worth. If the stock goes up, you need more capital segregated to cover the short. If the stock goes down, you require less.
Is Short Selling Ethical?
You make money as long as the shares go down and you buy them back at a lower price. As a short seller, you’re speculating that the price of the shares is going lower-that the company is getting weaker and running into problems that make their shares worth less.
This has many people against short selling; they argue that it is counterproductive to business. These people reason that the job of the stock market is to give businesses a way to finance growth and innovation, and short selling only serves to limit that ability. These viewpoints are misguided.
Traders are always going to buy and sell, and the order in which they do it is irrelevant. Is it unethical to sell a stock that you bought six months ago because it has given you a 100% profit? Most would say no, so why is it wrong to short sell a stock that has gone up 100% if it looks like it’s going to go lower?
Short selling is important because it helps take emotion out of the market and provide liquidity when few are willing to buy. If a stock is going up very quickly because investors are acting with greed rather than a rational assessment of value, the short seller can provide some strength to the sell side in an effort to balance the market.
More importantly, if the short sellers who acted when the stock was strong are proven right and the share price falls, it will be the short sellers who provide demand for the stock when pessimism is at its highest. You know that many investors are nervous about buying stocks that are in downward trends, but the short sellers will be motivated to provide some support to the stock so they can lock in their profits by covering the positions.
It is more difficult to short sell stocks, making it harder to make money from markets that are moving lower. In order to short a stock, your broker must have the shares to lend to you. Large, widely held companies are easy to short because there will be customers of the brokerage who own shares. Smaller companies without as many shareholders can be harder to short because your broker doesn’t have the inventory. I have found that many stocks I would like to short are not shortable for this reason.
STRATEGY OF THE WEEK
Stocks were hammered this week, taking the S&P 500 back to its long term upward trend line. This line provides good support for stocks so there should be a short term bounce back in the next few days. With that in mind, I set out to find stocks that have been sharply sold but which are showing some signs that a bounce back may be imminent. I did this with the following Market Scan:
Volatility Index = High
Candle = Bullish Candle
Gain/Loss > 1% over the last 1 days
Number of trades > 5000
Short Trend = Bearish
Medium Trend = Bearish
This scan found 77 stocks, here are four that I think are worth watching next week for a bounce:
STOCKS THAT MEET THAT FEATURED STRATEGY
ISIS is forming a rising bottom on the intraday after breaking the downward trend line, watch for a break up through $9.
GRMN is at long term support at $36 and closed above its open on Friday, a sign that the market will try to hold support. Stop loss it on a close below $36.
ALXN has been hammered lately but is building a base around $90, a break up through $91.75 should be the start of a bounce back on an intraday cup and handle break.
Has taken a bungee jump down to support where the elastic should be stretched out enough to recoil.
Stockscores Club Meeting and Mindless Investor Book Launch Special Event
Calgary Monday Nov 12
Vancouver Tuesday Nov 13
Click here for information and to register for this free event
This is not an introductory seminar, instead it is mean to show the application of my approach to the market. I will provide my analysis on current market conditions and show the processes that I do to find trading opportunities. Free to attend and copies of my new book, The Mindless Investor, will be available for purchase for $30. Please register to attend and let us know how many copies of the book you wish to purchase in the comments section of the registration page so we can bring enough copies.
Stockscores Trader Training
The 12 week Stockscores Investor and Stockscores Active Trader training programs start with the live Foundation class on November 24th in Vancouver and November 25th in Calgary. Click here to visit the information page.
Live Trading Day
For those who have completed the StockSchool Pro, Investor or Active Trader classes in the past, I will be doing a live trading day in Calgary on Monday November 26th. Watch me trade live and learn the processes I go through to find day and swing trading strategies. Emailtylerb@stockscores.com for more information.
Stockscores Market Minutes Video
There is always a bull market somewhere, this week I look at how to make money buying in a market that is falling. You can watch this week’s Market Minutes video on Youtube by clicking here. To receive email alerts any time I upload a new video, subscribe to the Stockscores channel at www.youtube.com/stockscoresdotcom.
- Get the Stockscore on any of over 20,000 North American stocks.
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- Strategies that can help you find new opportunities.
- Scan the market using extensive filter criteria.
- Build a portfolio of stocks and view a slide show of their charts.
- See which sectors are leading the market, and their components.
This is not an investment advisory, and should not be used to make investment decisions. Information in Stockscores Perspectives is often opinionated and should be considered for information purposes only. No stock exchange anywhere has approved or disapproved of the information contained herein. There is no express or implied solicitation to buy or sell securities. The writers and editors of Perspectives may have positions in the stocks discussed above and may trade in the stocks mentioned. Don’t consider buying or selling any stock without conducting your own due diligence.