I have been meaning to write this post for a few months now. The first draft has been waiting for me since October. Well I decided the wait is over. Here is how I short sell stocks.
Short selling can be very profitable. For the most part, breakdowns happen faster than breakouts, which is what peaked my interest in short sale trades. Most of the strategy that I am going to describe was taught to me by InvestorsLive, highly recommend his momentum chat. I did some studying to get additional technical and psychological insight to fine tune my strategy. I will continue to tweak it moving forward because "advancement does not happen without change"
Step 1 - Find overextended / parabolic charts
Look for charts that have gone straight up and are ready to pullback. These are charts that are extended from the short term moving averages. I use FinViz as one of my nightly scanners to get ready for the next trading day. I also look at RSI to look for extremely overbought (RSI>90) stocks. Just because a stock had a big move does not mean it is a short. Stocks can stay overbought for multiple days without pulling back.
Also be wary of huge gaps on earnings / news. These stocks do not have to come back down. Sometimes they just consolidate at higher levels to work out the overbought signal.
Once I find extended daily charts, there are two setups I really like to look for
Step 2 - Be prepared for the opportunity
Come to market early and ready. Have your plan ready and let the trade setup. I like to look for a weak open with no follow through, a failed red/green move or a gap up and parabolic rush. The failed red/green move works well with the topping candle setup and the gap up parabolic works well with the strong close setup, both of which are described and depicted above.
I like to use a 1/3 position size to start. This gives me the opportunity to be correct with a wider range. A one-third position allows me to use a stop up to three times my normal risk. The goal is to open your position near the top. Do not worry about being perfect. This is why you use a 1/3 position size. A small starter position takes emotion out of the trade for me. Look for clues such as whole and half dollar marks, round numbers, price action speeding up, etc. More about entries below.
Step 3 - Wait for a high of day and let a lower high confirm
Once a lower high is confirmed you have a potential downtrend. Lower high and lower low confirms a downtrend but you do not want to wait for a lower low. You want to add in after the lower high so that you now have a full position size. On washouts this may happen quickly so be ready to act. You want to have padding (unrealized profit) before adding in the remaining 2/3.
On a failed red to green move, I will wait for the failure then start a short sale position on pops. Notice the failure of red/green near 27 then lower highs and the steady fade. I will add in on the lower high.
On a parabolic move, I will open my position into the fast/sped up, vertical price action. Notice the gap up from previous close then it went straight up or parabolic. I will open my short position into the parabolic then add in on the lower high.
Step 4 - Locate support levels
You will want to know where buyers have shown up in the past. Many times these are round numbers, whole or half dollar marks. Also the previous close can act as support. Knowing trend line and price support levels allows me to set profit target areas. I usually pay myself on 1/3 of the position just above the first major support. This guarantees a winning trade. Some profits are locked in so emotions are in check. Then move your stop to your add in fill price and let it trade out.
Notice the 7.80 area support. I would cover 1/3 of my position to realize profits. Then the stock washed out through 7.50 where you can see the bottoming tail followed by higher lows. This indicates a change of trend and time to cover the remaining shares.
Step 5 - Ride the trend
I am a firm believer in not taking additional profits until there is a reason to. Stay alert for clues that indicate a reversal pivot point (near term bottom) and/or change of trend before covering the remaining shares. The goal is not to nail the bottom but to capture a large chunk of the move. I want to be near the bottom and reversal point. Some things to look for include a long lower tail on a candle and/or higher lows. See daily chart of ARNA above.
Remember you can always open another short position if the stock sets up again during the day or you can cover only 1/3 on short term bottoming signals if you want to keep a core short position. What I mean is cover 1/3 near first major support, cover 1/3 near the first bottoming signal, and let 1/3 ride. I do not recommend holding short sale positions overnight. The only way I would is if I have a lot of realized profits locked in and there is a high probability the stock falls further such as weakness into the close. Otherwise close out the trade and pay yourself.
I hope this helps. Be patient. Do not fight the trend. Know your plan and execute it. Oh yeah and follow me on Twitter!