How to make money selling stocks short in the stock market.
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William O.Neil. Founder of Investor’s Business Daily and author of the book featured in this video, How To Make Money Selling Stocks Short.
Stocks have a bias of increasing over the longer term and everyone has a story of a stock that has made a significant profit, but as the saying goes, what goes up must come down, often with a bang.
William provides detail on the anatomy of a short sale and provides many examples of making huge amounts of profit from selling stocks short.
Let’s take a look.
We present ‘How to make money selling stocks short’
In 1963 William O’Neil bought a seat on the New York Stock Exchange, a year later he started the firm William O’Neil & Co and twenty years later he founded the highly regarded ‘Investor’s Business Daily’.
Throughout this period, as you might expect, William O’Neil brushed shoulders with hundreds of investors, portfolio managers and institutional clients. He found there was a clear lack of knowledge regarding the selling of stocks and much less when selling a stock short. In fact, he concluded that there was a severe psychological block in anything other than buying and holding stocks.
William says;
“Buying without the ability to sell is like a football team that is all offense and no defense. To win, you must understand and execute both”.
A short sale is where the stock is borrowed from a broker and sold straight away at the market price, in the hope the stock can be bought back at a lower price in the future. This is the opposite of a traditional buy low and sell high strategy.
Let’s look at a quick ‘real life’ example before we move onto the technical aspects of a short sale….
David has a mobile phone with a value of $1000.
Dangerous Derek approaches him and politely asks if he can borrow the phone, Dave replies “sure no problem”.
A few moments later Derek is seen selling the phone to a passer-by for $1000.
A week goes by and Derek finds the same model phone in the shop window for $800, he purchases the phone, and returns to Dave to give it to him.
Dave has his phone back and Derek walks away with $200 profit, the difference between the $1000 sale price and the $800 purchase price.
The risk here is that if Derek had to buy the phone from the shop at a higher price, he would have lost money. Therefore, the challenge is to sell the asset at a high price in anticipation that the price will get lower shortly afterwards.
Let’s look at this from a stock chart perspective.
The trader in question was advanced enough to notice a head and shoulder pattern within this chart.
He could also see two inflection points which created a support line.
And, the price had extended way above its moving average line.
The trader kept an eye on this support level and once the price cut through support here, he borrowed shares from his broker and sold the stock short immediately.
The price drifted down as anticipated and the trader bought the stock back at a lower price, around the moving average area.
Therefore, if the stock was sold short at $10 per share and bought back at $5, the trader’s profit would have been $5 per share.
Let’s look deeper into the technical aspects and see some examples provided in the book.
William O’Neil says:
“it is best to time your short selling with the action and movement of the general market averages. After they show definite signs of weakness, only then does it become a question of selection and timing of the individual stocks to sell short”
We see here the example of the Dow Jones index in 1984 and the characteristics discussed by William.
Points A and B show signs of distribution, determined by lower closing prices from the previous day and high relative volume for each of those days.
William says when you see perhaps five distribution days within a 2 to 4 week period it is time to start raising cash.
There are however further key points to recognise prior to determining that the market is heading downwards.
Here we can see several distribution days, these pushed the price through its 200 day moving average.
Additionally (although not pointed out in the book) we can see the price also broke through a rising level of support.
This would be an ideal point to look for individual stocks which are ready to sell short. The rest of this video will be focusing on just that.
William O’Neil presented his anatomy of a short sale and this forms the basis of his strategy.
A typical action seen here at point B is what he calls the top, identified by heavy volume on a distribution day which also breaks a prior level of support, shown here.
This action is not the time you want to short sell a stock, but it would be a stock to put on your short list pending the next stage.
The next stage is here where price fluctuates around the 50 day moving average. At some point volume will start to diminish, signalling that demand for the stock is waning.
The signal and the moment to sell the stock short would be here at point 3, just as the stock turns down accompanied by high relative volume.
Some key notes to take from the book prior to applying this to shorting candidates are;
Firstly, make sure the overall market is in a downtrend, trying to use such a strategy whilst the general market is still bullish reduces the probability of success considerably.
Make sure the stocks identified as candidates for shorting have good liquidity, ideally 1 million shares on average should be traded each day.
Former leaders from a prior bull market often make good short sale candidates, momentum tends to fall even quicker than its original rise in price.
William also suggests waiting for the 50 day moving average to cross below the 200 day moving average, also known as the death cross seen here.
Finally, set a profit target of between 20 and 30% and look to take them often.
Let’s look at a sample of the many charts the book offers to better demonstrate the strategy in action.
The first chart presented is that of Cisco Systems a former bull market leader through to its peak of March 2000.
The death cross William discusses is seen here just as the 50 day moving average crosses below the 200 day moving average.
Also, notice how just before and at the point of crossover, there are several higher volume distribution days. Somewhere here would be the ideal time to sell the stock short.
An indicator leading to this trigger point and a reason for adding the stock to your watch list is seen here, a stalling period, or area of consolidation, accompanied by lower average volume. This suggests the stock is no longer in demand.
William also points out a secondary short point here, again a few weeks of consolidation, a bounce off the 50 day moving average and a spike in volume.
The stock eventually lost 90% of it’s value from the peak of March 2000, making this a great short sale.
Another favourite of the late 1990’s was a company called Corning.
Again, we see the death cross formed through the moving average cross over.
William suggests the point to short sell this stock would be here, after a failed rally above the 50 day moving average on a huge spike in volume.
The price dropped from $55 per share to less than $9 per share in approximately 9 months.
Finally, the chart of a company called Krispy Kreme Doughnuts, taken straight from the book.
We see the moving average cross over here.
A 4 week rising wedge on decreasing volume.
And a significant drop through the 50 day moving average on a huge spike in volume.
William says the optimum point to short sell would be here.
Additionally, although not highlighted in the book we can see a previous point of resistance here, right at the point in which the price bounces off.
A stop loss perhaps placed here above the line of resistance, would have created an excellent risk reward trade, possibly more than a 6 to 1 ratio.
The price eventually dropped from an entry of $34 per share down to $12 per share over a six month period. A great short sale example.
There are more than 150 stock chart diagrams within the book, all based on the principles shown in our examples. There is however a key warning provided regardless of the chart in question.
If stocks have been in a down trend for more than 18 months it’s likely you are too late to the shorting party, shorting stocks at such a late stage is risky and can have serious consequences.
For those looking to add short selling to their strategy, this book gives great detail through the many annotated charts offered.
I rate the book 4 stars and would recommend it to a more advanced level stock trader due to the inherent risks involved with selling stocks short.