The Dos and Don'ts of Short-Selling - TheStreet

It's shaping up to be an excellent season for short-selling, but chasing stocks to lower ground might not be the best way to play this falling market. That popular strategy gets overcrowded very quickly, triggering vertical squeezes that will wipe out the most promising short-sale patterns.

So, if you're having trouble getting your short timing right, take a giant step back and learn Farley's do's and don'ts of successful short selling.

DO

short rallies, not selloffs. In other words, enter positions when the major indices are overbought and pushing into obvious resistance levels. Other short sellers, i.e., your competition, get shaken out after prices creep higher for a few days, ensuring easier profits when the market finally rolls over.

Image placeholder title

DON'T

jump into short sales when the index futures get hit with automated selling programs, unless you're a daytrader that's prepared to scale out as the algorithms push into short-term support pivots. These programs are highly opaque, meaning you have no idea when they going to end suddenly and give way to a substantial bounce.

Retail HOLDRs

Click here for larger image.

Source: eSignal

DO

short the weakest sectors. For example, the

Retail HOLDRS Trust

(RTH) - Get Report

rallied up to resistance at the 200-day moving average and "round number" 100 in April, rolled over and broke the trendline of higher lows posted since March. A bounce back to that trendline will also tag the broken moving average, setting up a low-risk short-sale entry.

This small pattern on the major industry ETF also favors short positions in a wide variety of underperforming retailers that bounced after the March lows. My favorite setups include:

Gamestop

(GME) - Get Report

,

RadioShack

(RSH)

and

Saks Holdings

(SKS)

.

DON'T

short the strongest sectors. Top picking is a loser's game, even when it's played on the pages of

RealMoney

. You don't know when oil, steel or

Apple

(AAPL) - Get Report

will finally stop moving higher, and neither does anyone else. So just stop guessing and stick to short plays that have already rolled over and are starting to break down.

Dow Jones Industrial Average

Click here for larger image.

Source: eSignal

DO

watch the calendar like a hawk. Seasonal events like window dressing, first-day-of-the-month and options expiration can screw up the best short-sale patterns. For example, we've moved into the end-of-May/start-of-June after the market took a plunge last week. This period favors a bounce that retraces up to 75% of the short-term downtrend.

DON'T

short a dull market. The major indices spend four out of five days, on average, moving sideways and shaking out both long and short positions. It's your job to find the one day in five when the trend is alive and well. It's also your job to find the rare day when that trend is pointed lower, and not higher.

DO

short indices when stocks look confused and are pulling both ways. We've had multiple periods in the last few months when the major averages were selling off, even though a variety of sectors were running higher. Just short the weakest index ETFs when this happens, so you don't have to guess where all the buyers are hiding.

Homebuilders SPDR

Click here for larger image.

Source: eSignal

DON'T

avoid big-story short-sales. The homebuilder and financial sectors are stuck in major bear markets for obvious reasons. You can avoid most of the ugly shakeouts in these over-shorted stocks by dropping back to the weekly charts and using those longer-term patterns for sell and cover signals.

The

SPDR S&P Homebuilders ETF

(XHB) - Get Report

sold off from 40 to 15 in the latest wave of its long downtrend. The bounce off the January lows established a rising trendline that was broken during last week's selloff. An oversold rally that lifts the fund back into resistance near 22 will issue a strong sell signal.

Microsoft

Click here for larger image.

Source: eSignal

DO

watch closely for false breakouts. The most reliable short-sale signals will trigger right after a recovering stock pierces a notable resistance level to shake out other sellers, and then breaks down through the same level. The signal is especially effective when its ties into bearish price action in longer time frames.

Microsoft

(MSFT) - Get Report

violated its 200-day moving average earlier this year and then chugged higher in a bear flag that tested resistance in April. The stock broke out, held the moving average for two days and plunged back to flag support, triggering a failure signal. It broke the flag last week and is now rounding out a bearish head-and-shoulder top.

DON'T

get paranoid. Be patient while your short-sale positions set up for profitable breakdowns. Markets tend to fall fast and hard when they finally break, but cause a ton of second-guessing while they're probing higher levels. An even-minded personality and well-placed stop-losses will ease most of the anxiety while you wait.

Alan Farley provides daily stock picks and commentary with his "Daily Swing Trade" newsletter.

At the time of publication, Farley had no positions in the stocks mentioned, although holdings can change at any time.

Farley is also the author of

The Daily Swing Trade

, a premium product that outlines his charts and analysis. Farley has also been featured in

Barron's

,

SmartMoney

,

Tech Week

,

Active Trader

,

MoneyCentral

,

Technical Investor

,

Bridge Trader

and

Online Investor

. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks.

Farley appreciates your feedback;

click here

to send him an email.

Also,

click here to sign up for Farley's premium subscription product, The Daily Swing Trade, brought to you exclusively by TheStreet.com.

TheStreet.com has a revenue-sharing relationship with Trader's Library under which it receives a portion of the revenue from purchases by customers directed there from TheStreet.com.