Shorting Overbought Stocks

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Step number one is to identify the trend of the markets at the time

you are planning to short stock. For the best results, you will want

a market that is extended. The more parabolic the uptrend the better.

Another point you want to remember is the months that are

the most bearish from a statistical basis: September and October.

For example, if the month of August is bullish and the market

index is at an old or a new high, be aware that a bearish trend has

a high probability of occurring in September and October. Many

times after a summer rally, a sell-off of stocks will occur from

August into October. This is, of course, not always the case, but

over the past 100 years September and October have had a bearish

tendency.

Note in Figure 5.1 that the market is breaking above resistance

and heading for an old high. At the same time you can see that September

and October may possibly influence the current trend. Support

and resistance are always important to any bullish or bearish

analysis. The more parabolic the run over a short period of time,

the higher the probability of a reversal of trend. Remember the parabolic

rules from Chapter 4: (1) "When a parabolic run occurs,

expect a pullback of 30 to 50 percent." (2) "If a pullback does not occur, expect a consolidation." In case you have forgotten, a parabolic

run is a movement in price that violates the normal angle of

ascent and is greater than 45 degrees. A parabolic run is almost vertical

in nature. The parabolic rules are true for markets and for individual

stocks. See the example of a parabolic run (Figure 4.15) in

Chapter 4.

After reviewing the sectors and identifying individual stocks

that appear to be overbought, make your selection. You will follow

the stocks on this list until it is time to take action and short the

stock. The following factors are necessary for successfully shorting

overbought stocks.

1. Extended price trend

2. Parabolic run in price

3. Overbought technical readings on the following indicators:

106 the strategic electronic day trader

RSI (14-day)

CCI (12-day)

Bollinger bands

Moving average (3-day) EMA of the close rolling over

and changing the slope downward

MACD beginning to turn into a sell signal at price

highs (least important of the technical factors)

These factors are important for the microtrend and the intraday

trader. In fact, if a stock has these characteristics, it is an excellent

candidate for intraday trading. Now that we know how to screen

and select a stock that is overbought, let us begin to examine specific

information that should improve your intraday trading.

Intraday Shorting of Overbought Stocks

"Short stock intraday? Shorting is risky enough as it is, and you want

to short intraday?" This is the typical reaction of nonprofessionals.

This response is based on emotion, not on knowledge or experience.

To the layperson, it seems a risky venture, but the fact is that

shorting intraday is safer in many ways than holding a short position

for a long period of time. If you are using a shorting strategy,

you need to know a few important pieces of information. If you

examine trend direction you will find the bias of the stock market is

upward. This upward bias has been the case for over 100 years and

is not a modern statistical aberration. Because the bias of the market

is, in fact, upward, your stocks will be candidates for shorting

only 5 to 20 percent of the time. This means that on a percentage

basis, you are usually long 95 to 80 percent of the time. When you

look at intraday trend trading, the picture changes dramatically.

Remember, on average, markets and stocks fall 67 percent faster

than they rise, and in some cases price will drop 80 percent faster.

This rapid drop can compound money at an unbelievable rate.

Trading the downtrend of a stock is essential for success in the market,

and nowhere else is this more obvious than in intraday trading.

Intraday shorting is subject to rapid and volatile changes in

trend. This is due to traders trading different time frames on an intraday

basis as well as other factors that contribute to momentum. You can be the beneficiary of this intraday volatility by knowing when to

short. When you examine the intraday bias of stocks, they tend to be

40 percent bullish, 40 percent bearish, and in consolidation 20 percent

of the time. As an intraday trend trader, you do not trade consolidations.

This means that when you trade intraday, you are long

50 percent of the time and short 50 percent of the time. The 50 percent

of the time you are short has the potential to compound money

67 to 80 percent faster than trading the long side of intraday trend.

When you are looking for intraday overbought conditions, you

will be using 5- and 15-minute bar charts. The 15-minute chart confirms

the trend and break of the 5-minute chart. You are looking for a

stock that has an extended chart pattern and, if possible, a parabolic

run for the last one to three bars. Figure 5.2 is an example of a possible

intraday trend that is ready to begin a bearish intraday decline.

Figure 5.3 shows a 15-minute chart of the same stock and confirms

the current trend of the 5-minute chart. You can use the 5- and

15-minute charts to approximate the turning point of a stock that is

overbought and parabolic. Often the 15-minute chart will show you

a chart pattern, such as a symmetrical or ascending triangles, that

may not be as well defined in a 5-minute intraday chart. I will give

you an example of this from an actual real-time trading experience.

I was following Lucent Technologies, symbol LU, and the 5-minute

Used with permission of Townsend Analytics, Ltd.

chart was in a high-low trading range and was hitting what at the

time was resistance at $68. It broke through resistance and moved

to $68 3/16, then fell back to $68. I was going to go long the stock, when

I glanced at the 15-minute chart. Clicking on a trend-drawing tool, I

drew a line connecting the lower upward-moving lows of the trend.

I realized that the 15-minute chart showed the formation of a symmetrical

triangle and that we could be near the apex of that triangle.

My first instinct was to go long from $68, expecting a breakout

above resistance to $68 1/2. That is exactly what I would have done if

I had not had the 15-minute to confirm the trend and pattern. Ten

minutes later, the stock broke through the apex of the triangle and

moved downward throughout the rest of the day.

Fifteen-minute charts do not always show chart patterns, but

when they do, you need to pay attention. Not doing so could cost you a

lot of money. The 15-minute chart will show trend direction and trading

range. You base your buy and sell decisions on the 5-minute chart. This

time frame tends to give signals that are less distorted by speculation.

When you trade intraday, you need to have 5-minute, and 15-minute,

and daily charts showing at least three months of daily price information.

See the example of a 15-minute intraday chart in Figure 5.3.

Another reason for considering an intraday short position

would be a strong downtrend in the major markets. If the markets

are topping out or beginning to decline, in most cases your stock

will follow. If you are trading stocks on the Nasdaq and you are

watching only the S&P 500, this could be financially fatal. Many

times, markets will trade independent of each other. I suggest that

you follow the S&P 500 and the Nasdaq markets. Have these markets

charted on your computer screen so you can monitor them at

a glance. Figures 5.4 and 5.5 show five-minute charts of the S&P 500

and the Nasdaq markets. (In Chapter 8, the details of setting up a

trading room will be addressed, including screen configuration,

hardware, monitor array, and other information.)

In both charts you see the intraday trend moves of the markets.

This becomes important in your timing decision to go short or

long, because most of the time you want the market to be in sync

with the direction of your trade.

Electronic Shorting Using ECNs and Level II

When you short a stock while trading electronically, you have control

over risk that no other form of trading can give you. If you are going to short or use leverage of any kind, you need to be able to

manage the risk of the trade. In my opinion, this is the most important

advantage of electronic trading. You click your mouse and two

to six seconds later your bought or sold confirmation is on the

screen. As I have said before, trading online through an Internet brokerage

firm is not going to give you the risk control you need to

trade intraday. You need the speed and reliability of being able to

route your order over the proper ECN at the price you select.

Because you are trading electronically using ECNs and Level II market

maker screens, you have the necessary information to short the

stock and control the risk. Here is an example of how to use this

information to sell short intraday.

The S&P 500 and Nasdaq are beginning to top out and the stock

you have targeted to short has run parabolic for the last 15 minutes.

You feel very confident that the market and the stock will begin an

intraday downtrend. Wanting to sell short, you look at the Level II

market maker box and here is what you see.

The bid is currently an uptick expressed by the up arrow to the

side of the bid. NITE is currently bidding at 23 5/8 and GSCO at 23 9/16

Given the following positions of market makers NITE, GSCO, SCWD,

and the ECN ISLD, here are several ways to short XYZ stock. Assuming

that the 5/8 is an uptick, you could hit NITE at 5/8 by routing the

order through the Small Order Execution System (SOES). In this

specific case, you would want to use a SOES limit order, not a SOES

market order, the reason being that if NITE drops the bid after filling

a previous SOES order, it will cancel your order and you will not be

able to hit GSCO at 9/16. You cannot SOES a market on a downtick. If the

bid had several market makers present at 5/8 and the market showed

an uptick, you could use a SOES market order. Always remember to

check the size (number of shares) on the bid and ask before you

place any trade. With several market makers at 5/8, you would haev

enough supply to fill your short order. The probability of all market

makers dropping at the same time before you filled your short

would be slim. It could happen, but the odds are in your favor.

The market maker SCWD is on the offer (ask), offering stock at

$23 3/4. If you wanted to sell short on the offer (ask), you could

join SCWD, routing your order through Island (ISLD) and short at $13 3/4.

In the following example, Island (ISLD), an ECN, is at 235/8 on the

bid, and market maker Goldman Sachs (GSCO) is at 23 11/16 on the

offer (ask). If the bid is an uptick, then you can hit ISLD, selling short

and routing through ISLD, but if the bid is a downtick, then you join

GSCO on the offer (ask) at 11/16 on ISLD. Remember, you cannot hit

ISLD on a downtick, you cannot SOES selling short on market downticks,

and you cannot SOES an ECN.

The previous examples have shown various ways of using Level

II information to sell stock short intraday. To make money from intraday

shorting, you are going to have to buy back the stock to profit

from the trade. Sometimes a novice or even an intermediate-level

trader will become confused by shorting. Old habits die hard, and it

is easy to make a mistake because shorting is the opposite of what

you normally do. When you short, your first step is to sell the stock,

the opposite of buying. To take your profit on the stock, you buy it

back. When shorting, you sell to buy and buy to sell. Here are several

examples of covering (buying back stock) to take your profit. Do not

confuse this with the term short covering, which usually is synonymous

with buying back the stock at a loss to protect yourself from

the stock moving higher. Let's look at several examples of how to use

Level II information and how best to route your order.

In the following example, NITE, a market maker, is on the bid at

$305/8. INCA, an institutional ECN, is at $30 11/16, followed by market

maker GSCO at $30 3/4. You cannot use a SOES market order because

INCA is an ECN, and, as you know, you cannot SOES an ECN. The best

way to buy back your stock and take a profit in this specific example

is to use the ECN Archipelago, known by the symbol TNTO or ARCA.

By routing the order on Archipelago, you are able to hit INCA at 11/16 If

INCA lifts the offer, your order will then hit market maker GSCO at 3/4.

Covering Short Reading Level II

You might be thinking, "If I can use Archipelago to hit an ECN

and a market maker, this would be the best routing choice." If you

did, it would be a serious error that could cost you thousands of

dollars. Archipelago (TNTO) has what is known as SelectNet preference.

This means that an order coming in through TNTO gives it 20

seconds to acknowledge, and it does not have to fill your order until

then. A lot can happen in 20 seconds. Archipelago can be effectively

used to hit ECNs in specific situations that appear during a trading

day. Let's look at some specific examples.

The following example shows how to use Archipelago to cover

your short position. MASH, a market maker, is on the bid at $285/8.

REDI and BRUT, ECNs, are on the offer (ask) at $28 11/16. You want to

buy back 1,000 shares to take a profit on your short position. In this

case, you use TNTO to hit both ECNs: REDI for 500 shares and BRUT

for the balance. This would be far better than trying to use SOES to

hit GSCO for the full 1,000 shares. This trade also puts time on your

side because by using TNTO to hit the ECNs you will be in front of

the SOES crowd trying to hit the GSCO.

The following is another example of how you could use TNTO

to your advantage. ISLD is at the bid at 405/8, showing 1,700 shares.

On the offer (ask) ISLD, GSCO, and INCA are at 40 11/16. All are showing

various numbers of shares they are offering out for sale. If you had

to buy 2,000, you would use TNTO. You might be able to get the full

1,000 shares from ISLD, but if GSCO is in a 17-second refresh from

being hit by a SOES trader, you could lose your opportunity. By routing

the order through TNTO, you can be more certain of being

totally filled with the 2,000 shares. If you had to fill only 1,000 shares

or less, the preferred and fastest way to route would be ISLD, SOES,

and then TNTO.

Let us take a look at another situation that comes along quite

often. Many times, the spread on the bid and the ask is very small;

in rare cases, they will both show the same price. In some cases,

you may, in fact, want to cover the position on the bid and not the

offer (ask).

ISLD is on the bid at 335/8 with 1,700 shares, and GSCO is on the

offer (ask) at 33 11/16 with 1,000 shares showing. If you want to cover

your short position quickly and fill 1,000 shares, you need to buy

back on the bid. If ISLD is showing 1,700 shares, you can feel reasonably

confident of getting the full 1,000 shares, because ISLD has

no refresh policy. That is not the case with GSCO. Once GSCO has

filled 100 shares of a previous SOES order, it has 17 seconds to

refresh before it accepts the next order. If your order arrives during

the 17-second refresh, you may not get your price or the number of

shares you need. In this case, it is in your best interests to sell at a

lower price. Being greedy and trying to make that last dime is financially

dangerous. I have known individuals who have lost thousands

of dollars trying to get that last 1/8 of a point. This little personality

flaw is a ticking time bomb. Acknowledge the problem and correct it

before your account blows up and you become another notch on a

faster trader's gun.

Understanding how to use Level II information and how to

route the order is critical to all short-term traders, especially day traders. This technology is light-years beyond trading online. In

most cases, your trade is transacted is seconds and the confirmation

is on your screen before an online trader can type two symbols.

It is my opinion that in five years most online brokerage firms will

shift from their current methods to the use of ECNs. Why would anyone

want to use traditional online methods when they can have the

speed and power of trading like market makers?

Shorting at the Wrong Time

Before we move into an in-depth analysis of shorting tactics, we

need to answer the question, "Why do most individuals short at the

wrong time?" The first thing you need to understand is that individuals

for the most part do not short stock. Professionals do most of

the shorting, and it is usually related to hedging a portfolio. When

individuals do short, timing and analysis do not seem to be factors

in the decision process. It appears that they short stock from an

emotional reaction rather than as a strategy. I have examined thousands

of short trades made by individuals. Here is a brief scenario

of my observation on shorting.

The typical mistake that individuals make when they short is

jumping in too late in the downtrend. In many cases, the trend may

have lasted for a month or two. About this time, a news event comes

out on XYZ company and catches the attention of Sam Novice.

Because the news is negative, Sam assumes that no one is going to

buy this stock and that most people are going to be net sellers of the

stock. Wrong! This same event becomes the catalyst for a reversal in

the downtrend. Value fund managers have had their collective eyes

on XYZ stock for some time. The news caused the stock to move just

a few points lower. Now the stock is down almost 50 percent and

value fund investors feel compelled to buy the stock because they

believe it is "cheap." About the same time, several astute technical

analysts see that XYZ is at a long-term support area and in a Fibonacci

retracement zone. Other analysts notice that the stock is in a pivot

zone where rebounds have taken place before. Big money is getting

ready to go long two days after Sam shorted the stock. In Figure 5.6,

the arrow at point A shows where Sam shorted the stock and the

arrow at point B shows where big money is getting ready to go long.

In this example, Sam would have been much better off shorting

if the support area did not hold. He could have placed his stop

above support, identified by the arrow at point C.

In the second scenario, Sam has been watching a stock for a

few weeks and decides that it is excessively high. What is he basing

his decision on? He simply has a hunch that the price is "just too

darn high." So Sam shorts the stock. Sam knows nothing about topping

patterns or technical indicators; he just reasons that no one is

going to pay higher prices for that particular stock. Sam helps the

stock move even higher because he is forced to cover the stock.

One month later the stock is just starting to consolidate after moving

higher.

In Figure 5.7, the arrow at point A shows where Sam

went short. Never make the mistake of arbitrarily deciding the

stock or a market is too high without data to support your contention.