This is the second part of a previous blog from a couple of years ago explaining the fundamentals of short selling. With this we are going deeper into tools available for technical analysis required for good short selling.
How Does a Short Sale Work? A short sale of securities takes place when the investor sells a block of stock that he/she does not own. To do this, the investor’s broker must borrow the stock on the investor’s behalf from another investor, usually from the broker’s own inventory. At the time of the short sale, the investor receives cash for selling the position and a debit on his statement showing that he has borrowed shares that must be returned. Done properly, the stock would decline in value and the investor could then buy the shares on the open market at the cheaper price, covering the position at a discount and keeping the difference. The beauty of it is that the short position can generate a profit without tying up any additional capital.
Short Sale Analysis: Using analysis tools acquired from the broker, the private investor can make lists of stocks that are “sell” rated. By screening these stocks, the investor then can develop his own short sale watchlist, and can track how the target stocks are doing. The analysis process includes both functional and also a lot of technical analysis. In the functional analysis process the private investor culls the watchlist for those stocks that are doing well functionally, i.e. they have good revenues, they are good earning stocks, they have few liabilities and good cash flow, etc. Those stocks are all screened out, because the short sale investor is looking for just the opposite. Weak fundamentals do not automatically make for good short sale positions—some stocks have reasonably good fundamentals, but for some reason they just don’t trade well. The use of fundamental analysis is important but is often eclipsed by technical analysis. What makes up technical analysis is all about the performance of the stock’s price. Such items as trending, relationship with the 50-day and 200-day moving averages, volume, and whether the stock is under accumulation or distribution are all paramount. The direction of the fifty, and two hundred day moving averages can tell the analyst what the short term and the long trends are like. So can the MACD-LT, and MACD-ST that summarizes the trend. MACD stands for moving average convergence or divergence, with LT meaning long-term, and ST meaning short-term. As the moving average of the stock changes each day segments will tend to point into the direction of the trend. Volume is something that by itself is not that meaningful, but when compared over a period of time it can show if the stock has strength. The strength of a stock is the best measurement of whether it has “legs” and will continue to rise during a rally. This attribute is determined by whether the stock is under accumulation or distribution, and is measured by analyzing the volume of the last fifty trading days. If there is more volume on the up days, the stock is considered to be under accumulation. More volume on the down days, then it is under distribution. The current price is considered to be the analyst’s most important tool.
Other Tools:
VIX: Also known as the “fear” index the Volatility Index is a real-time index that represents the market’s expectations for the relative strength of near-term price changes of the S&P 500. It manages to do this by examining a portfolio of put and call options on the S&P 500. A put option is the option to sell a stock at a certain price, whereas the call option is the option to buy at a certain price. Options have time limits, and their value is very often impacted by the time remaining until they expire. The changes that take place with options can form the VIX.
Cyclical Trend Index: The underlying premise of the Cyclical Trend Index, or CTI, is that the market, specifically the Dow Jones Industrial Average (DJIA), tends to move in cycles that can resemble sine waves. There are five identifiable cycles, each with different time durations, at work in the market at all times. As these cycles reset, they can point to either bullish or bearish upcoming conditions.
Momentum Index: The market’s momentum is measured by comparing the strength or weakness of several broad market indexes to the DJIA. Readings of -4 or lower are regarded as bearish since it is an indication that a majority of the broader based market indexes are weaker than the DJIA. Conversely, readings of +4 or higher are regarded as bullish. Any reading that falls between the two numbers implies that the momentum index is in neutral ground.
Advance/Decline Line: Also known as the A/D line, it tracks the number of stocks that advanced each day versus the number that declined. It is a single number that is impacted by the changes taking place each day, and works for separate market places such as the NYSE (New York Stock Exchange), or NASDAQ. It is a good indicator of breadth in the markets, and can also help point toward the market’s future direction. It is included as a component of the Momentum Index.
Sentiment Index: This index seeks to measure bullish or bearish sentiment in the markets. It works by combining a series of other indexes the are compiled together. Some of those component indexes are as follows: Dividend Yield Spread, Bullish Investment Advisors, Bearish Investment Advisors, Bullish-Bearish Investment Ratio, The VIX, Put/Call ratio, and others. For investors, sentiment is an attitude or judgement prompted by a feeling of how the future will play out.
Short Sale Timing: Good short sale strategy includes careful timing. Attempting to time market swings is usually a mistake as markets don’t always act in predictable ways. However, the best timing for a short sale could be when the stock market has topped out—not when it is already in deep decline or when it is on a bullish rally. When the market is riding high, analysis tools will show the strength of those stocks that are tapering off. Short sales also mean short duration—strictly a timing mechanism used for downturns and not necessarily a good acquire and hold strategy. An acquire and hold short sale strategy carries too many risks and/or complications for most private investors. Although shorter duration is often preferred, the longer the pullback, the longer the duration.
Risks: When considering risk with trading short positions, the investor must always keep in mind that there is practically no limit to the size of the loss that a short position can obtain. A long position is limited by the amount that the investor pays in, and no more. But the short position must be covered by the purchase of shares enabling the investor to close the short position. Even without sound functional financial traits, a stock (especially a start-up) may be able to stay in business by constantly selling shares. This not only keeps them in business but may also create at huge price one day for covering short. Short sellers would be squeezed whenever that happens. Sudden run-ups owing to good news such as the discovery of a new medical product, could also create a run-up of the stock and squeeze the short sellers. As each short seller buys the stock to cover his/her short position, the price gets bid up higher making the remaining short shares in greater jeopardy.
Conclusions: Short selling is an endeavor that calls for careful preparation and monitoring. What it brings to the private investor is the opportunity to make gains when the stock markets are in decline such as the early days of the Covid 19 lockdowns. Private investors should always retain the proceeds of short sales in their brokerage accounts and not invest them in other assets. Why? If the cash to cover is not readily available, the investor must borrow it from the broker and pay interest up to as much as 8.5%. If a private investor is borrowing money for shorting stocks and reinvesting the proceeds, he/she needs to earn more than 9% to make the effort worthwhile. Only hedge funds can usually do that as they will invest up to 30% more than the total assets in the fund.
Sources:
Investopedia, CBOE Volatility Index (VIX): What Does It Measure in Investing? By Justin Kuepper, August 7, 2024.
MarketEdge Weekly Market Comment, November 1, 2024.