Shorting the market

Not many traders or investors understand know how to short the market.

Many consider it unpatriotic and most of them are fearful

It is considered to be something for experienced traders only.

As a trader and investor, I do not see why we should not short the market. Based on my system, I go long and short based on what I see on the fundamental, technical and sentimental factors.

From 1983 to 2006, which was mainly a bull market, 65% of companies underperformed and 32% outperformed the market. 25% of stocks account for 100% of index return. That's mean there are 3 out 4 stocks are short candidates.

Also, adding negative bias is a good hedge to your portfolio.

If you use covered calls and collars for bullish bias trades, why not use synthetic puts and reversed collars for negative bias trade.

Actually, I made a lot of money from shorting the market during the Asian Crisis in the 1990s and the dot.com bust. I missed the mother of all bears in 2008 but finally caught up by the end of that year.

Let me explain what are the mechanism I use to short the market

First, you need to understand the risks. It has unlimited downside and limited upside. Even if the stock goes to zero, you made at the most 100%. I did short a few stocks during the dot.com bust until the broker called to ask me to buy back the shares. The companies were bankrupt. But if you are wrong, there is unlimited lost. This is probably the fear of most investors when shorting stock.

The key is risk control. I always had a stop loss for my shorts. You have to be very disciplined. If you are wrong get out. The market can over extend itself for a while. Nowadays, I use options and not "stop loss". I will explain on the mechanism of the trade.

A person holding the stock will have to pay for the dividends when it is due. So normally, I will not short high dividend stocks unless I am very negative on its underlying fundamentals and technical outlook.

Downside cycle is usually, fast strong and violent. It is usually faster than stock rising on a bull trend. Thus, money can be made very fast if you are right.

Always be prepared for a short squeeze especially after a huge downturn with high volume. Once you made some quick money, I normally advise that you put a floor to the profit by selling some puts.

I always avoid shorting stock that has a high short interest. The squeeze can be tremendous.

Remember that stock can remain irrational longer than you can remain liquid. So get out when you are wrong and choose a right timing to get back if you still believe that you are right eventually.

How to start?

First look for stocks that are fundamentally weak. Examples - lost market position, high debt, low intrinsic value, losing market share,legal problems, declining profit etc. In this blog I have examples of short trades like Palm, AIG, GE, LVS, DHI. I had made money on all the shorts except for GE. LVS is a recent trade. I have also shorted stocks like GCI, F, CPLA and STX on my portfolio which is not on the blog.

Personally, I am still shorting GE. I am convinced that the fundamentals are overwhelmingly weak. It will take time for me to be right. On my portfolio, despite the fact I was slightly wrong on the trend, I am making a little money on GE and still holding on to bearish positions.

Usually, I start with a covered put ( Short stock + short put OTM) or reversed covered call. Following are some conditions:

o The stock is fundamentally weak
o It has been over extended by a bull market and is hitting resistance.
o Overall market is also hitting resistance
o Wait for a confirmation of a bearish breakdown. Usually, it could be a DOJI at the resistance,a hangman, a bearish engulfment, on the candlestick, MACD and Stochastics turning down, and a drop from a longer term descending channel.

If I am right on the trade, I will normally roll the SP down out. Sometimes, if the trend is clear, just take out the short put but be prepared to add a SP once the market seems to hit some support.

Do not add the SP too fast. Wait for stock to clearly show some support. Sometimes it is better to just get out. As for Palm, I shorted the stocks at 16, adjusted the SP at least 3 times ( with 1 credit and 2 debits ) before I got out at 8. It was still too early but good enough for more than 100% gain in 4-5months.

If I feel that longer term the stock is still weak and poised for further downside, I can add an OTM protective Call to make it a reversed collar. Often it is better to get out if I am wrong and reenter the trade again ( just like GE). But sometimes, it is also good to reverse collar the position. ( short stock, SP and protective LC ).