The Art of Safe and Profitable Shorts

Yesterday I talked about going long in a bearish market. Today, I'll tackle the flip side, and talk about going short.

But first, a couple of words on going short in any market: It's hard.

That's right, when you go short, it is a very hard trade to make, not mechanically, not philosophically (at least for me), but sociologically. Huh?

OK, what I mean by that is you're going against the very nature of 99% of the people who participate in the market. People don't generally root against stocks, they root for stocks. People see a stock going down and don't assume it's dead but rather "on sale."

In fact, for many people, owning certain stocks is a religious experience. Sell Cisco (CSCO Quote)? Hah, you're off your rocker! But sell short Cisco? You need a lobotomy, and fast!

So, taking all that into consideration, you'd think that selling short never would be profitable and should never be profitable. I've read where a veteran trader like George Soros has said he rarely makes any money on the short side. William J. O'Neil, stock chartist and founder of Investors Business Daily, advises to completely avoid going short.

And I understand all that. And avoiding the short side is probably something most of you should do. That said, if you master a few fundamentals, going short can be safe and profitable. In fact, very profitable. But, you absolutely have to keep in mind a few ironclad rules that I never violate.

These rules are particularly important in a down market:

No. 1: Never let your profits run on the short side. Never. Yes, stocks can crater and you can wind up with 30% or 40% gains. And we've had one of those days recently.

More often than not, bottom-fishers come in during the day and bid those prices right back up. This past Friday, they didn't. This past Friday was an exception.

So, I advocate setting a profit target at some fixed percentage -- mine is 5% -- and cleaning up your position at that point.

No. 2: Never short a stock that's been down a few days in a row. Oh, it looks enticing, but what you're invariably doing is shorting right into a bounce, dead-cat or otherwise. And those bounces can be nasty, and they will shake you out.

No. 3: Always use a stop. Even if it's a mental stop. I've seen stocks rebound in this market and ramp up 50% within a few hours. Probably better to cut your losses before that happens.

OK, if you follow those three rules, you will do just fine. Now, let's look at the type of entries I advocate, moving from easiest to hardest. Some of these you may have seen in my past columns, while some are new, and specifically geared for bear markets.

The first type is my standard break from congestion. Nothing fancy here, just look for a straight, but broken support line, and high volume.

Next up is the break from an upward trendline. This is almost identical to the congestion break, but often works better because the violent downside move comes as a complete surprise to those long the stock.

The next type of short is geared specifically for bear markets. Remember, that when stocks are in a downtrend, they rarely go straight down. Instead, they go down a little, then move sideways into congestion, and then go down again. This intermediate congestion is a bit shorter than the type I showed with LifeMinders.com (LFMN Quote), but works almost as well.

My final type of short is one that can send shivers up your spine. This is the type that should be labeled, "For advanced traders only!" But, in reality, it's just the exact opposite of buying on a dip in a bull market. Except, the "dip" with a short is a pullback to resistance.

Now, why are these scary? Because in a bear market, snapback rallies are fast, furious, and seemingly, never-ending. You're essentially shorting into the hopes and wishes of millions of shareholders.

So, in order to protect yourself, you have to look for two things. One, volume must be dropping off on the rally back up. Two, you must use some kind of stop in case you're wrong, the trend has changed, and the stock is moving back into bull country.

Those are the types of shorts I look for, and that you should be familiar with. This doesn't mean, by the way, you ever have to play the short side. But, if you happen to be long a stock that sets up into one of these patterns, know that the odds of your stock going down further have just increased dramatically.