June 12, 2007 at 5:12 pm | | Comments 3

Finding Short Sale Candidates

Last week’s market pullback after a very long upside run might have been a change of character. In fact, with Friday’s bounce now having failed, the charts are suggesting some further downside may be in store. When considering the psychological changes that can come with a sudden, sharp correction after such a steady uptrend, there just might be a shift to a more defensive posture by the longer-term players. Bulls with nice gains to protect sometimes view subsequent bounces as second-chance selling opportunities, which can certainly have a slowing effect on the advance, and Tuesday’s turnaround is in line with that. Further, the bears who have been waiting so patiently might now begin to view this recent market weakness as an opportunity.

I’m no perma-bull or bear, I simply let the charts be my guide when it comes to trading the long or short side of the market. However, there are a few things I’ll point out when it comes to finding short sale candidates after a big advance like we’ve had.

It’s important to note that although trading the short side is technically just the reverse order of a long-side trade (with a short sale you sell first and buy back later), in practice it can play out very differently. We’ve already discussed how to get short, but let’s examine 4 related and important characteristics when locating high-probability short selling candidates, just in case this market is undergoing a change of character.

Volume. Trading the short side presents a completely different animal than the long side when it comes to trading volume. To move higher, a stock needs strong volume with new buyers entering the picture to produce greater demand on the shares, so long-sided trades should show improved relative volume. On the flip side, stocks don’t need high volume to move lower. In a skittish market, buyers who are bidding for shares may simply cancel their orders. That means that volume can actually diminish while the supply vs. demand relationship changes. The “heavy” supply in relation to the lighter demand is what leads to the phrase, “stocks can fall of their own weight.”

Chart Patterns. There are a number of bearish chart patterns which represent the psychology of buyers and sellers, helping to provide an edge on the short side when they surface. Being able to locate and correctly diagnose these patterns will help you locate higher-probability trades than arbitrarily deciding that a given stock “looks expensive.”

Failing Bounces. The description speaks for itself, but a failing bounce occurs when a stock has corrected, is trying to recover or “bounce”, and it becomes apparent that the upside momentum will fall short of reaching the previous peak. Initiating a short sale into a failing bounce can present a clear-cut exit (buy to cover at the previous high) as well as a nice entry for when the next wave of selling hits the stock.

Lower Highs. Failing bounces lead to lower highs on the charts, so having a few already in place should mean a downtrend is being established. Each time a stock attempts to recover, it comes under selling pressure again as weak holders unload shares in an effort to raise cash. Lower highs increase the odds of success when trading the short side, implying that the stock has already “topped out.”

Trading the short side can provide you with some nice profits when done properly, and also can be a nice natural hedge against long positions when corrections come. The market isn’t always in bull mode, so keep an open mind to the short side and one of these days you may be glad you did!

Jeff White
President, The Stock Bandit, Inc.
Swing Trading & Day Trading Service

[tags]Stock Market, Day Trading, Stock Trading, Investing, Swing Trading[/tags]

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  1. Short sales are looking even better right now. I noticed the inventory is raising locally. Might be a good thing for investors. Maybe a real estate short sales are a good investment these days.

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