Weekend Strategy Review May 21, 2016

Posted by OMS  at May 21st, 2016

The Dow rose 65 points on Friday, closing at 17,500.   It was down 34 points for the week.  The NASDAQ was up 57 points on Friday and up 52 points for the week.

Friday’s small rally appeared to be part or all of a small wave 2 up within a declining Rounding Top pattern.  The Dow did not break below 17,485 on Friday, so neckline support of the Head & Shoulders pattern within the Rounding Top continues to hold.  Once this neckline is broken, an impulsive decline should start with prices moving below the 17,000 level.

I received several questions about short selling recently, so I thought I would use this weekend to discuss the process.  In Class, I talk about a plumber coming to your house to fix a pipe and how he uses all the tools in his tool box to do the job.  Well, it’s the same for a trader.  If you’re going to make money in the market, you’ve got to learn how to take advantage of both the up and down moves.  Selling short is just another tool.

Here’s how it works: 

For example, let’s assume that you believe that Caterpillar (CAT), which is currently trading near 70, will fall to the low 60s. 

The first thing you need to do is borrow the shares you want to sell from your broker.  This happens automatically when you press the ‘Sell Short’ button on your trading platform.  You simple put in the number of shares you want to sell short, and the price you want to sell them at. The magic of computers does the rest.

Once you press the button, your broker’s computer looks into all his accounts to find the shares you want to borrow, and tries to sell them at the requested price.  If you place a market order, the shares you borrowed are sold immediately.  To keep track of the shares you borrowed, your broker’s computer places an ‘IOU’ in the account from where it borrowed the shares.  Because most shares in brokerage accounts are held in “Street Name”, the person from whom the shares were borrowed never knows that the shares have been sold. Only the computer knows.

Once you’re short, you simply wait for the price to fall (hopefully).  Let’s say that CAT starts to decline and reaches your half-way target, so you want to take some money off the table.  The next step is to repurchase the shares and return them to whoever you borrowed them from. This is accomplished by pushing the ‘Cover Short” button on your trading platform.  Again, you simply indicate how many shares you want to buy back (cover) and the price you want to pay.

If the share price fell during the trade, you pocket the difference between what you sold the shares for and what you paid to buy them back.  It’s just the opposite of what happens on a long purchase.  Let’s say that CAT fell 5 points during the trade.  If you shorted 500 shares at 70, and the price fell to 65, you profit would be $2,500 (less commissions).   However, if the price of CAT went up during the trade, you would have lost money.

Selling short requires a margin account because you’re borrowing the shares (money).  It cannot be done in an IRA.  This is why I trade inverse ETFs in my IRA because they can be purchased long.  However, because inverse ETFs are complex vehicles that use a combination of futures and options to try to match the performance of the underlying index, there is a lot of slippage in these ETFs.  This is why I only like to trade them for short periods of time.

Also, when you’re short the shares, you have to pay any dividend that is declared while you borrow them.  The dividend goes to the actual owner of the shares.  The amount of any dividend will be deducted from your account.  It’s not a big problem today, because most of the stocks I short don’t pay dividends.  But the dividend declare date is always something to check before deciding to short a stock.  That way, even if the stock pays a dividend, you can avoid it by not being short on the declare date.

Anyhow, that’s a quick overview of selling short.  It’s just another tool for your trading toolbox.  Don’t be afraid of this tool. It’s something that all of my students should understand and learn how to use.  If the Dow starts to break below 17,485 in the days ahead, we’re going to be doing a lot of shot selling.

Have a great weekend.

That’s what I’m doing.

h

Market Signals for

05-23-2016

FAQ

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