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Short Stuff

Gary B. Smith

Yikes! The market was nasty last week -- at least from the long side. But, boy, you'd have had a ball on the short side ... if you were playing that side. Which, of course, most of you weren't.

No, you're in there trying to find that bottom, potentially plunging yourself deeper and deeper into a big sinkhole. And if you're not, my hat is off to you, sir or madam, because you are a far better stock-picker than me!

Me? I just like to go with the trend and take the easy way out. If the market's going down, then I'm Senor Short. If it's going up, then I'm Larry Long. (And if it's choppy, I'm Oscar Outtaluck!)

But to continue what I started in Monday's column, let me give you two examples of what I like to look for in a short candidate. I'll step you through each one, with the exact orders I'd give to enter, take profits and prevent massive losses.

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The first type of short is a clean break from a upward-sloping trend line. These can also be viewed as breaks from support, especially if the upslope is relatively gentle. Either way, Fleetwood Enterprises (FLE Quote) provides a good example of a nasty break. With these, and really any type of shorts, I look for three important items:

1. The break comes on volume much larger than average.

2. The break is "clean." That is, if it made a sound, it would sound like a broken leg. A nasty broken leg. In fact, you should be able to easily draw either the support or trend line and tell exactly when the break occurred.

3. The break must be the first break, not the second or third. Said another way, prior to the break, all should be well and good with the stock. Longs might be nervous, but they still feel OK. Said still another way, the stock should most definitely not be in a long, nasty downtrend!

OK, let's take a look at Fleetwood. On the left side is my entry order. On the right side are my exit orders.

A few things to note. One, it's always a good idea to make sure your broker can secure the shares for you to borrow before you assume you can sell short. Most brokers, though, will let you know that shortly after you enter your order.

However, I have found wide variances among brokers (actually, their clearing firms) on short availability, so if shorting is or might be a big part of your strategy, it pays to shop around. For some examples of my own search, see my first, second and third columns on "Penny Wise, Pound Foolish."

On the orders I entered, be very careful about choosing "day only" or "good till cancel," or GTC. Sometimes you won't get filled on short because there was no uptick, but because you made it a GTC order, you'll get filled the next day ... as the stock is rocketing back up.

In addition, I made my entry a market order. However, it's perfectly legitimate to enter with a limit order. There are pros and cons to both, but basically it boils down to getting a better fill with a limit order but potentially missing the trade vs. catching more trades with a market order but getting worse fills overall.

Finally, I made up the stop and limit targets. In general, though, I use fixed percentage targets (historically, a 5% target, 6% stop). Others like to put their stop slightly above resistance (with Fleetwood, the gap at 19) but still have problems figuring out where they should take profits.

In that regard, if you remember no other rule about shorting, remember this: Always try to take your profits quickly. Always. I would rather get out in one day with only a 4% gain than wait around three days or even a week for a 15% gain. There is just too much working against you on the short side to be dawdling with taking profits. Upgrades, takeovers, mergers, a market ramp. Believe me, there is no pain like the pain of one of your shorts going up 30% in a day. So move in and out of your position quickly.

The next example is one that scares people a lot, but it's one of my favorites: the huge, gaping drop down from support. The reason people shy away from this situation is because they say, "My God, XYZ dropped 25% in one day! Surely folks will swoop in and buy this stock, and my short will get killed!"

And that makes a lot of sense, right? Unfortunately, it just doesn't work like that. Oh, sure, you sometimes get a swift rebound the next day, but here's the interesting part: Those rebounds tend to come right at the open, giving you an excellent short entry!

Another point to remember on giving your short order: The correct terminology to close your short is "buy to cover." I've made the mistake of saying "Buy 1000 ONE" and wound up the next day with a short position and a long position, so be careful.

These are just two examples, but they capture the essence of how I like to go short. Specifically notice how I never tried to pick a top or a reversal? Those are simply low-odds plays, and strictly for either gamblers or people with cast-iron stomachs. Unfortunately, I suppose that's what people think you have to do when you go short: Pick a top in something like VerticalNet (VERT Quote)!

Well, if you want to go that route, then shorting is hard. It's also stupid. No, as I said earlier, it's much easier and simpler to just pile on a stock that's already broken. Now, if you want more examples, there are many others in my column archives, so check those out, starting with the GBS Primer Column last May.

If you never get there, though, here are the important points to remember about shorting, or at least the GBS version of shorting:

1. Only pick on stocks that have broken down from support or an uptrend.

2. Only pick on stocks that have broken down with heavy volume.

3. Never short a stock that is already in a deep swoon. Instead, only short stocks after their first collapse from either a healthy or, at worst, neutral situation.

4. Use the correct terminology when entering and exiting your position.

5. Think ahead of time where your stop and target will be. This is so critical, it probably should be repeated.

6. Think ahead of time where your stop and target will be!

7. Be impatient about taking profits.

There. Now you have it. All the tools to go forth and be a bear. Just remember: Start slowly and be careful out there. Paper-trade until you think you know what you're doing. Use small orders until you get your confidence. Because until times change, the bulls out there can be a darn stubborn bunch.