Your Shorting Strategy: Deciding When to Buy Safely - dummies

Your Shorting Strategy: Deciding When to Buy Safely

By Paul Mladjenovic

Timing is everything with short selling, so technical analysis is valuable. Sellers in the market may not immediately recognize that a company has bad fundamentals (identified from fundamental analysis). Sometimes the stock of a bad company trades in a narrow range and doesn’t break to the downside until some months have passed.

You could have the right shorting candidate but the wrong time for shorting. What if this is an exuberant bull market and all stocks, both good and bad, are rising?

This is why technical analysis can be valuable. Some folks who do short-term trading rely strictly on technical analysis, but blending both approaches makes it a better bet, especially if you’re a novice to short selling.

The double top pattern

Technical analysts look at chart patterns to see where the stock’s price has been so they can get clues about where it may go. They check for resistance and support levels for a given stock:

  • Resistance: Resistance refers to the price level that seems to act like a glass ceiling to a stock’s price movement. In other words, the stock’s share price keeps failing to break through this price level.

  • Support: Support acts like a floor that the stock price is able to bounce back up from reliably.

In a double top pattern, the stock price has made at least two runs upward but in each case was stopped at a particular level. This pattern may indicate that (for now, anyway) the stock has run out of steam on the upside and may be bracing for a pullback. Double (and even triple) top patterns tend to be reliable, so topping patterns are taken seriously.

If a company with bad fundamentals is also experiencing a topping pattern, this could indicate trouble for the stock’s price — and opportunity for short sellers.

Bollinger bands

When a stock price is zigzagging up (or down), it tends to move in a channel. Bollinger bands are lines that delineate both the top and the bottom of that channel; they typically follow not the actual stock price but an averaged price, such as a 21-day moving average.

If the stock’s average price moves above the top of the band, the stock is considered overbought, and if it goes below the bottom band, it’s considered oversold. When a stock is overbought, that means that it shot over a sustainable price level and is vulnerable to a significant decline.

Given that, a short seller will use Bollinger bands to see whether the stock is overbought and will time the short sale at that point to anticipate the decline.

The Relative Strength Index

Another way to check whether a stock is overbought or oversold is through the Relative Strength Index (RSI). The RSI is an indicator that looks at the technical momentum of a stock and compares the size and strength of recent price gains to recent losses. If the stock has an RSI rating of more than 70, it’s considered overbought. If it has an RSI rating of under 30, it’s oversold. Therefore, an RSI greater than 70 would be another nail in the coffin for that stock — a good sign for short sellers.