How to Short Stocks with Confidence and Make Big Money in Bear Markets

Special Report authored by Dr. Bart A. DiLiddo

 

WALL STREET WISDOM

There was time when it was said that the surest way to make money in stocks was to hold them for the long-term. Anyone who thought otherwise was called a speculator, trader or momentum player. It was alleged that "buy and hold" investors were sure-fire winners. As a result of the 2000-2002 bear market, hardly anyone believes this anymore.

 

The most widely published evidence that buying and holding is not the best way to make money in stocks was presented in an article printed September 27, 2002 in USA TODAY. It featured a chart showing the up and down movements of the Dow Jones Industrial Average from 1966 through 1982. The point of the article was that the Dow opened 1966 at 983.51 and closed 1982 at 991.72. Up 8.21 points, less than one-percent, in 17 years!

 

The USA TODAY article, "Timing is Everything When Stocks Stall," showed that there were six Bull markets and five Bear markets during this period of time. Had you bought the Dow at the beginning of each Bull market and gone into cash at the beginning of each Bear market, you would have gained 549%. Had you ridden the Dow up in each Bull market and sold it short in each Bear market, you would have gained 2,680%.

 

This example clearly shows that buying long in bull markets and selling short in bear markets is a much better strategy than buying and holding stocks for the long-term. So why does the conventional wisdom on Wall Street teach us that "buy and hold" is the best investment strategy? Why does it tell us you can't "time the market," and warn us against selling-stocks short?

 

The reason is obvious: The Wall Street brokerage houses and mutual funds want to control your money at all times. Selling stocks when prices go down is very bad for business. Not only does it reduce the assets from which they make money, but it drives stock prices lower which makes them look bad. Brokers tell you to buy, buy, buy because they don't want to offend the companies they represent. They say you can't time the market because it supports the argument of staying long all the time. They are against selling short because it rubs their customers the wrong way. Incidentally, you are not their customer. You are the victim of their clever marketing schemes.

 

THE BASICS OF SELLING SHORT

The whole idea of selling stocks short is to make money from stocks that are going down in price. It's the exact opposite of buying stocks long expecting that they will go up in price. In selling short, you sell stocks that appear to be high in price and buy them back at lower prices. For example, let's suppose XYZ is trading at $23.00 per share. You think it could go down to a lower price. So you call your broker and say, "I want to sell N shares of XYZ at $23.00 per share or higher to open."

 

Sounds good, but selling stocks short involves selling something you don't own. Somehow this has a bad ring to it. How can you sell something you don't own? Don't worry about it. It's done everyday. For example, you subscribed to the morning paper. The publishing company did not have tomorrow's paper printed when they took your order. So they actually sold tomorrow's paper short.

 

Now the publisher has the responsibility of putting the paper together and delivering it to you as promised. You expect that they will because they have done it over and over before, but you have taken a risk. The publishing company also took a risk in accepting your order. They have to get the paper to you at a profit. Otherwise they eventually will go broke. In summary, you took a risk in buying something the provider didn't have. The provider took a risk in delivering it at a profit. Most businesses are run this way. So selling short is NOT a bad thing.

 

MARGIN ACCOUNTS

You need to have a margin account in order to sell stocks short. A margin account allows the broker to extend credit to you in accordance with Federal Regulation T of the Federal Reserve Board. If you do have a margin account and you place an order to sell short, the broker will check to see if you have sufficient cash in your account to satisfy Reg T. This means that you must have at least 50% of the amount involved in short-selling the stock in your account as cash. This cash shows that you have sufficient funds available to buy the stock back should it go against you.

 

Once the broker verifies that you have sufficient cash in your account to make the trade, he or she will borrow the requested shares of stock, and credit your account for the amount received from selling the stock. In the case of selling short 100 shares of XYZ, you would need to have $1,150 of cash in your account and you would receive a credit of $2,300 less commissions. Overall, you would have a credit balance of $3,450 in your account.

 

Can you go out and spend this money? Not on your life. At least not until the price of the stock starts going down. Let's suppose XYZ goes to $18.00 per share. You've made $500. Your credit balance is still $3,450, but the market value of the stock is only $1,800. So your equity is $1,650, ($3,450 - $1,800). Although your paper profit is $500, but your buying power is now $1,500, ($3,300-$1,800). This is the amount you can spend to buy stocks long or sell stocks short.

 

Although you will always pay interest on money you borrow from the broker, most brokerage houses do not pay interest on the proceeds of short sales. You may, however, be able to negotiate an interest payment if you have a sizeable account. You will also be charged by the broker for any cash or stock dividend payments on your short positions.

 

WHEN TO SELL SHORT

The first step to becoming a successful short-seller is to know when to sell short. Everyone knows that even the very best stocks go down in bear markets, and the very worst stocks go up in bull markets. The trick then, is to buy stocks long when the market goes up and sell stocks short when it is going down. This is called "Timing the Market."

 

The single most important thing in making money in the stock market is knowing whether the market is going up or down. Without this information, you will never be able to short stocks successfully.

 

TIMING THE MARKET

VectorVest has been sensing the direction of the market for over 20 years. This was done originally by analyzing the percentage of Buy, Sell, Hold recommendations given to the stocks in our database. The ratio of Buy to Sell recommendations, (BSR), is an excellent indicator of the market's trend. When the BSR is rising, the market is getting stronger and stock prices are going up. When the BSR is falling, the market is weak and stock prices are falling.

 

Starting in 1995, the information provided by the BSR was augmented by analyzing the movements of the Price of the VectorVest Composite. The VectorVest Composite, (VVC), is the arithmetic average of all the stocks in our database, over 7,500. When the Price of the VVC goes up, the market is going up. The reverse is also true. Our basic system of timing the market is described in Chapter 20 of "Stocks, Strategies & Common Sense." For your convenience this system is summarized below:

 

The VectorVest Market Timing system is based upon two simple rules:

1. A trend is signaled when the Price of the VectorVest Composite moves two consecutive weeks in a given direction.

2. An upturn is confirmed when the BSR is greater than 1.00, and a downturn is confirmed when the BSR is less than 1.00.

 

Buying stocks long on confirmed up signals and selling stocks short on confirmed down signals has been shown to produce very good results. If one could buy at the exact bottom of a downtrend and sell at the exact top of an uptrend, i.e., the market turning points, the results would be absolutely phenomenal. We don't claim to have ever called a turning point. We have come very close on numerous occasions, however, because we strive to make our calls as close to the turning points as possible.

 

Our record of timing the market is exemplary. VectorVest subscribers have demonstrated the ability to turn $10,000 into more than $10,000,000 on numerous occasions using our actual calls in backtests of their own design. The techniques for doing this are taught at our Seminars and Courses.

 

Just as we are proud of our record of signaling market direction we are also pleased to have never missed a major trend. For more information on "Timing the Market" read our Special Report called the "Color Guard," which is available in your software.

 

WHAT STOCKS TO SELL SHORT

The bull market of 1991 led to the demise of many short sellers. From what I could gather, these individuals not only persisted in selling stocks short in up markets, but they also sold the wrong stocks. Many of the classic short sellers look for fine companies that they think are beginning to falter. Or they think they have spotted some hanky-panky going on with a company's books. Whatever the case, you don't have to be an accounting genius or a detective to find stocks to sell short. VectorVest does the work for you.

 

VectorVest believes in selling risky, overvalued stocks short when they are going down in price. Since VectorVest analyzes, sorts and ranks over 7,500 stocks each day for Value, Safety and Timing, and gives Buy, Sell, Hold recommendations on every stock each day, it is able to provide a number of ways to find risky, overvalued stocks to short that are going down in price. Virtually all of these ways may be implemented with the UniSearch Tool.

 

FINDING STOCKS TO SELL SHORT

The best way to find stocks to sell short is to use the UniSearch Tool. This unique tool is so powerful that it makes finding appropriate stocks to sell short a piece of cake. VectorVest illustrates the application of the UniSearch via an ongoing series of tutorials called the "Strategy of the Week," (SOTW). Examples of recent SOTW's for selling stocks short with annualized performance records are shown below:

 

 

The best way to learn how to conduct these searches is to print the detailed SOTW instructions and click your way through the procedure. Consider going to a VectorVest User Group if one in nearby, or attend one of our Seminars or Workshops. You may also call Product Support at 1-704-895-4095 from 8:00am-10:00pm EST, Monday - Saturday for assistance.

 

SHORTING STOCKS WITH CONFIDENCE

1. Here's a step-by-step procedure showing you "How to Short Stocks with Confidence and Make Big Money with Confidence."

2. Prepare yourself to sell short by backtesting over and over again.

3. Paper trade in real time. This is a very important step in learning to implement any strategy...especially selling short.

4. Start out with very small positions. No amount of back testing and/or paper trading can give you the experience and knowledge of actually managing a portfolio. So start out small. Don't become impatient. Another downturn is always around the corner.

5. Act when the market is entering a downturn. VectorVest will identify this event in VectorVest Views when it happens.

6. Select a strategy. If you have prepared yourself properly via steps (1) - (3), you should know which strategies are best for you. However, VectorVest always suggests to its readers several strategies which may be used to sell stocks short in the Model Portfolio.

7. Follow our Model Portfolio as a guide. Please be aware that the Model Portfolio is managed mechanically for illustrative purposes, and is not managed to maximize profits. We try to keep things as simple as possible, and do not make intra-day trading decisions that an experienced investor would normally make. Don't try to follow what we do because you will always be a day late. Learn how to anticipate what we probably will do.

 

THINGS NOT TO DO

1. Never sell stocks short in a rising market. This point has been made several times already, but it's worth repeating.

2. Never short a stock that is rising in price. The worst mistake that the losers of the 90's made was shorting stocks that were rising in price. Nobody knows how high a stock can go, so never short a stock that is going up in price. VectorVest's Relative Timing indicator makes it extremely easy to know when a stock is in an uptrend or a downtrend.

3. Never take a big loss on a short position. VectorVest provides a Stop-Price on every stock in its database. This Stop-Price is designed to serve as a guide for covering stocks that are short as well as selling stocks that are long.

4. Never own a short position in a stock that has a "B" recommendation. A stock's price needs to be above its Stop-price and rising in price to get a "B" rating in the VectorVest system. Therefore, owning a short position on a "B" rated stock violates rules (2) and (3).