All investments involve taking either a long or short position. Individual investors are generally more familiar with going long, which means buying a stock that you think will go higher in price. But in bear markets, where everything seems to go down, for those wanting to profit from an expected decline in price, an investor can take a short position.
Short selling means that you sell a stock you don’t own. To short a stock, you will first need to borrow it from your broker. Brokers can use stock from another investor’s account to loan it to you or they might borrow it from another brokerage firm. After you make the short sale, the proceeds are credited to your account. Eventually you will need to close the short position by buying back the same number of shares and returning them to your broker. If the price drops, you buy back the stock at a lower price and make a profit. You will suffer a loss if the price of the stock rises because you have to buy it back at the higher price.
There are a couple of reasons to short a stock. The most obv just to bet on lower prices. If you think a stock is overpriced, shorting it gives you an opportunity to turn your opinion into potential profits. Another reason to enter a short trade is to hedge a long position. If you want to continue holding stock for the long-term, but fear it is overvalued in the short-term, you could reduce that short-term risk by shorting the stock or an index related to the stock. If the price declines, you will not suffer any loss since the short profits will offset the long losses.
The question investors face is when to go short. It is easy to say that stocks are overvalued. For example, in the Internet bubble in the late-1990s, stocks with no earnings sold for hundreds of dollars a share. Yet, many large investors went broke trying to short them – the market had become irrational. The great economist John Maynard Keynes is believed to have said, “The market can stay irrational longer than you can stay solvent.”
Technical analysis can be used to find overvalued stocks that are likely to decline. In the bubble at the end of the twentieth century, stocks were very strong and went up in price, despite the fact that they were fundamentally overvalued. Technical analysis looks only at price to determine the trend, ignoring earnings and other fundamental criteria.
A simple tool to find short candidates is to determine the trend with a moving average. Looking at a 200-day moving average, you would only short stocks trading below that indicator. Figure 1 presents an example of this idea. The price of the S&P 500 index crossed below its 200-day moving average in December 2007 and remained below it throughout the devastating bear market of 2008 and 2009. Looking at a chart with this single indicator would have shown investors it was best to avoid long trades.
Figure 1: The S&P 500 fell below its 200-day moving average since December 2007 and stayed there throughout a 50 percent decline.
The moving average tells us what side of the market to be on – long if the price is above the moving average or short when price is below the moving average. Timing the trade entry and exit can be done with another indicator. Figure 2 shows a trade using the Relative Strength Index (RSI). This indicator measures how fast prices are rising or falling, what technicians call price momentum. Momentum often moves ahead of price, and when it gets too high, a market is said to be overbought and is likely to fall. Oversold conditions occur when prices have fallen too far and, in theory have nowhere to go but up. One way to trade RSI is to buy when the indicator crosses from an oversold condition to the normal zone and sell on a reversal from overbought levels.
RSI values are always between 0 and 100. When the stock is below the 200-day moving average, we want to take only short trading signals. In a bear market, the oversold level for RSI is 60. The red arrow in Figure 2 shows where price crossed below the 200-day moving average and RSI fell below 60. The green arrow shows the first time after that when RSI rose above its oversold level of 20.
Figure 2: The S&P 500 chart is the same timeframe as Figure 1, with RSI added to provide timing signals.
This simple strategy provided a profit of more than 33 percent. The rules are simple:
- Sell short when RSI falls below 60 and the stock is trading below its 200-day moving average.
- Cover the short and close the trade when RSI rises above 20 or price goes back above its 200-day moving average.