Sell short only when the market is in a clear bear market trend, and as early in the bear market cycle as possible. If you are shorting late in a bear market, after the market has been trending lower over many months, you may very well be late to the party. Short-selling very late in a bear market can be catastrophic, so beware of this. In particular, if the market has come down significantly off its peak and everyone around you is talking about selling the market short then be especially attuned to the contrarian implications of such a bearish preponderance.

Focus on those "big stock" leaders that had huge upside price moves in the immediately preceding bull market phase and that are showing significant topping signs. This means you will likely only be dealing with a relatively small universe of proper short-selling candidates.

As we will see later in this chapter, major topping formations, such as a head & shoulders top, can take 8–12 weeks or more after their absolute tops to develop. Some can take longer, and in some exceptional cases can take only a scant few weeks before a stock literally appears to blow out of the sky. The critical point in most short-selling cases is that bullish sentiment in a former, big winning leader is often very persistent in the stock. From a psychological perspective this makes perfect sense, since human nature is pretty much what it is and has always been. Investors who missed the big "rocket stock" and never bought it as they watched it go higher will see it start to break down off its peak for the first time and want in on the missed opportunity. Brokerage analysts may come out and recommend the fallen leader as a "strong buy" because it is seen as "cheap" after the sharp price break off the peak. In this manner, "residual" bullish sentiment in a former leader will persist in bringing money into the stock and bouncing it back up within its pattern. It takes time to wring out all of the bullish sentiment in a stock, which is why most short-sale candidates take 8–12 weeks or more to set up properly before they break to the downside. In most cases, larger-cap stocks with a broad institutional following will take longer to break down, while relatively smaller stocks can tend to break down much more quickly, usually within 12 weeks of their price peaks.

Seek to short former, big leading stocks 8–12 weeks after their peak price following a major upside price run.

In most cases, "big stock" leaders will be fairly liquid traders with average daily trading volume well in excess of 1–2 million shares. In general, we prefer a minimum of 2 million shares in average daily trading volume for our short-sale candidates. Stocks that trade a few hundred thousand shares a day should generally be avoided, unless an investor intends to deal in much smaller position sizes relative to one's account equity. We also impose an absolute maximum position size for stocks trading less than 1 million shares a day at less than or equal to 0.5 percent of the average daily trading volume. Therefore, for a stock that trades 300,000 shares a day, an appropriate maximum absolute position size of 1,500 shares or relative position size of 5 percent of one's account equity, whichever is less, is recommended for less than the most seasoned short-sellers. Stocks that trade only a few hundred thousand shares a day are quite thin and hence subject to very rapid price run-ups, which can cause a great deal of damage, even if your position size is relatively small. Therefore, Golden Rule of Short-Selling rule #4 is:

Only sell short stocks that trade a minimum of 1–2 million shares a day, and preferably more. In general, avoid thinly-traded stocks as short-sale candidates, as risk can correlate inversely to a stock's trading liquidity.

Stop-losses on short positions should range around 3–5 percent. If you are down 3 percent on a position and the stock is trading above-average volume as it rallies from your short-sale point, it is best to implement the 3 percent threshold for your stop-loss with the idea that the stock can always be re-shorted if the rally suddenly fizzles out. Also, if a stock you are short generates a pocket pivot type of upside buy signal, you can often just cover the stock right there. Otherwise, if the stock is rallying weakly, a 5 percent stop can be used, sometimes 1–3 percent more if so desired. Stops on short positions are still dependent on one's position size, personal psychology, and risk tolerance. One way to handle stops is to use a "reverse-layering" technique by "peeling off" portions of the position as a short position rallies against you, say of the position when it is 3 percent above your short-sale price, another when it is 5 percent above, and the last once the stock has rallied 7 percent past your short-sale price point. Other "permutations" of this strategy might be the position at 3 percent and the other at 5 percent, or at 5 percent and at 7 percent. As you gain experience in short-selling, you might find a particular permutation of stop-loss policies that works best for you, but whatever the case it is extremely important to always have a clear exit plan and point for any short position that is taken. Standing in the way of a sharp rally through indecision or hesitation, what we refer to as "freezing up," can be very dangerous. Hence, Golden Rule #5 states:

Set stop-losses at an average of 3–5 percent, using the tighter 3 percent stop if the stock begins to rally against you on strong, above-average volume. A "layering" technique can also be used by "peeling off" and covering portions of the position as the stock rallies against you a series of specified percentage thresholds, such as covering at 3 percent, another at 5 percent, and the final at 7 percent, or any other permutations. Stops are dependent upon personal psychological preference and risk tolerance, so short-sellers should try to determine what works best for them in real-time.

Because stocks will often have sharp upside rallies within their macro-downtrends, it is wise to set reasonable profit objectives for any downside move you expect a stock to make once you have taken a short position in the stock. In most environments profit targets should be 20–30 percent. If you find that short positions are breaking closer to 15–20 percent before rallying and wiping out your profits, then you can adjust this, or again use a "layering" technique where you cover the position when it is showing a 15–20 percent profit and the remainder when it is showing a 20–30 percent profit.

Alternatively, the 20-day moving average can sometimes be used as a guide for a trailing upside stop on any short position that is showing a decent profit. Once a stock has broken down from a proper short-sale set-up and topping formation and has been in a downtrend for at least a few days to a few weeks, the 20-day is often a useful reference point for a legitimate upside turn and rally in a stock, and hence offers what can be a nearby trailing stop. In Figure 6.1 we see First Solar, Inc. (FSLR) as it broke down from a large, wide, loose, and improper late-stage cup-with-handle type of formation. Note the loose and very long handle with very few tight weekly price closes. This is the macro-formation from which FSLR topped in late 2008.

Figure 6.1. First Solar, Inc. (FSLR) weekly chart, 2007–2008. FSLR tops out in a big, late-stage-failed-base short-sale set-up.: Chart courtesy of eSignal, Copyright 2010

Figure 6.2. First Solar, Inc. (FSLR) daily chart, 2008. The 20-day moving average provides a useful guide for a trailing stop as the stock breaks down and rapidly trends lower.: Chart courtesy of eSignal, Copyright 2010

In Figure 6.2 we can see FSLR's breakdown in detail on its daily chart. The stock breaks support along the lows of the handle at around the 250 price area, which corresponds to the weekly chart in Figure 6.1 which is the macro-view. After FSLR breaks decisively through this support zone in the lows of the handle, it stages one rally back up toward resistance and the 250 price area. Because (1) the stock did not move above the intraday high of the first day that it closed above the 20-day moving average and (2) the move up into the 20-day also corresponded to solid resistance at the 250 price area and the lows of the handle, this would not be considered a cover point, necessarily. However, notice that the move from 250 down to 200 represented a 20 percent profit, roughly, so part or all of the position could have been covered there, nicely illustrating the implementation of the 20–30 percent profit objective rule. The stock could have then been re-shorted on the move back up to the 20-day moving and the lows of the handle, which represented stiff potential resistance at the 250 price area.

Note that as FSLR came down to the 100 price level it bounced once and then re-tested that 100 low by coming down to a point just below it, setting up an "undercut and rally" situation, which also provided a potential profit-taking/short-covering point. Watching for lows that are retested and undercut can be useful in determining when to cover part or all of a short position, as it is very common for stocks to fake out shorts by undercutting a prior low, whether near-term (within the last week or two) or intermediate-term (several weeks to a few months), which is seen as a "breach of support" that is simply too obvious to work. Hence stocks will have a tendency to "undercut and rally" as they trend lower. Watching for such undercuts can help determine when a short position should be covered in part or in total. From this we derive Golden Rule #6:

Once a short position is showing a profit, set a downside profit target objective of 20–30 percent or use a "layering" technique, covering the position once a 15–20 percent profit is showing, and the other at a 20–30 percent profit. Alternatively, once a short position is showing a good profit one can use the 20-day moving average as a guide for a trailing stop. If the nearest moving average above the stock's current price is the 50-day or 200-day moving average then they can be used in place of the 20-day moving average line. Watch also for undercuts of prior lows as potential rally points at which all or part of the position can be covered.