Short Strategies [BRIEFING.COM - Robert Walberg]
In last week's brief entitled, Can't Beat 'Em, Short 'Em, Briefing.com discussed why investors might want to expand their investment horizons and consider the idea of short selling. Short selling is the practice of borrowing stock from a broker and then selling that stock. At some future point in time, the investor must buy those shares back, or cover his position, and return them to the lender. The goal is to buy the stock back at a later date for a lower price, pocketing the difference between the sale and the purchase price.
Considering that the major market indices have posted double-digit declines in each of the last three years, playing the short-side of the market has been an extremely good way to hedge against, or profit from, the market's broadbased weakness. Clearly, there's no guarantee that the indices will continue to falter in 2003, but early indications suggest that we could be in for more of the same. Not only did the major market indices end the key month of January with losses, but breadth and volume indicators remain sickly, the threat of war continues to thwart the economy and paralyze the market, and the long awaited earnings turnaround remains more fiction than fact.
As we noted last week, short-selling isn't for everyone. To the contrary, most investors disregard the practice either from lack of knowledge or from disdain for the very idea of profiting from weakness. Nevertheless, market conditions dictate that investors think outside the box if they want to increase their chances of preserving, protecting and growing their capital.
Briefing.com's discussion of this investment practice shouldn't be misconstrued as a call on the market, or as a suggestion that the average investors should start to aggressively short stocks. We are merely attempting to educate and inform investors about an investment strategy that has paid handsome returns to those that have practiced it with skill over the past few years. Like any investment approach, it takes time to learn what works best for you. And even then, if the market moves broadly and decisively against the strategy employed, there's not much hope of success - just ask all the buy and hold folks.
With these caveats aside, Briefing.com will now share some short strategies employed by traders that have enjoyed success in recent years. Whether any of these strategies will work for you depends on your investment profile, goals, etc.
Falling Below 200-Day Moving Average
One sign that a stock is losing momentum, and vulnerable to additional weakness, comes when it falls below its 200-day moving average. This signal is especially valuable when it occurs at a time when the market is flat, or higher. In other words, the stock has not only taken out an important technical floor but it is also showing relative weakness - falling, while other stocks are holding their own or climbing. Listed below is an example:
You can see from the chart that Wellpoint Health Networks broke below its 200-day moving average in decisive fashion (big down day on surge in volume) back in late November, when the broader market was trending higher. Two sessions later the stock was down by another 12%. Subsequent recovery tries have failed at the 200-day moving average, suggesting that a test of the November lows is likely in the days ahead. Fact that the 50-day moving average also fell below the 200-day moving average lends credence to the bearish outlook for WLP, as does fact that stock fell sharply yesterday even after posting better than expected earnings.
Momentum Stocks Reporting First Disappoint Revenue/Earnings Number
Those investors that followed this strategy when the tech sector was first rolling over not only spared themselves a lot of grief but probably banked some profits along the way. Shown below is a recent example:
Select Comfort was clearly riding the momentum wave as it tripled in price in roughly four months. However, the stock took a big intra-day hit last week when it reported Q4 earnings. While the Q4 numbers were impressive, momentum investors lost their appetite for the stock when it noted that Q1 revenues would be essentially flat compared to Q4 and that Q1 and Q2 earnings would be slightly below consensus estimates. The stock fought back hard on the the day of its report to close with only a modest loss, but then it tumbled by as much as 21% over the next few sessions. Often when a momentum stock reports a disappointment - especially when the headline is relatively positive, short traders will wait to sell the bounce off the opening drop. In this case, that would have been a very profitable move.
Failed Bounce
More of an in-and-out strategy, some day traders will look for stocks that finish at, or near, their lows going into the close and then sell the attempted bounce on the next morning. Whole Foods (WFMI) provided a good example of such action last week:
Back on 2/3, WFMI closed down sharply on the day and just above its lows. Also notable was the big jump in volume. Next day, stock tried to push higher off the open, providing the short seller his/her opportunity to move. By end of the session, the stock was down another 1.65 points - providing a quick in and out move of 3.4%. Should note that WFMI also broke below its 200-day moving average on 2/4 amid hefty volume and that the stock has continued to lose momentum ever since.
30% Rule
Another strategy employed by short sellers is to short stocks after they've experienced a one-day decline of 30% or more. Declines should occur on sizeable volume and the stock price should be above $7 - after the decline. Typically such a decline only occurs if there's been a major change in the company's underlying fundamentals, and the more severe the problem the better. A big earnings miss, while problematic, can be corrected quickly and, as such, is a less reliable short in this case. However, studies have shown that stocks meeting the above criteria make for decent intermediate-term shorts, as about 75% of the time they are down big 3-, 6- and 12-months after the one day drop. And, considering that the stocks typically hold up reasonably well on the day immediately after the big plunge, short-sellers have a decent entry opportunity. Providian Financial (PVN) is a good example. Stock tumbled 34% back on 10/12/01 to close at 13.45. Volume that day surged to over 25 mln shares. The next day the stock gained $0.20. However, 3-months later the stock was down by an additional 66%. PVN bounced back a bit over the next few months but was still down by 43% 6-months later. But one year after the date of the big one-day drop, the stock was back down by 67%.
Conclusion
These are just a handful of strategies used by traders. There are many, many more, most of which include a variety of nuances. Should note, however, that from what traders tell us shorting on overvaluation alone is rarely successful. For those investors more interested in the subject, we suggest taking a look at the reading materials suggested in last week's brief. You might also check out one or two web sites geared toward short selling. Just go to Google.com and type in short-selling and you'll find a number of sites.
If any of you have strategies and examples that they would like to share, please email them to me and if there are enough I'll post a follow-up Brief.
Robert Walberg , Briefing.com |
