Find short candidates with technical analysis

When shorting stocks, one is often faced with the challenge of distinguishing between a top formation and a change in trend. Many successful short sellers will try to focus their efforts by looking at cues offered from the schools of technical analysis and fundamental analysis. Read on to find out how studying these different methods can give a trader confidence in shorting the market.

Technical Analysis

Since the stock markets are mainly dominated by long traders, short traders try to prey on the weak longs to cause breakouts and start downtrends. They try to put enough pressure on the market to create situations where the weaker ones get out long because of the fear of giving back profits. It is the job of the short seller to find tools such as different chart patterns or indicators that are specifically used to predict the beginning of a decline or a panic sell.

Trying to short a market using technical analysis usually means finding an overbought indicator and a trend indicator that is reliable enough to show that the stock is a candidate for a downward move. The overbought indicator is most likely either a relative strength index (RSI) or a stochastic oscillator. A trend indicator can be as simple as a short-term moving average (MA).

When using an oscillator, the trader relies on it to show that the market has reached a level that indicates it may be running out of buyers. A trend indicator, on the other hand, is usually used to show that support has been broken because the market has turned weak. When a stock is short, it is very important that the trader knows that with an oscillator they are selling strength, but with a trend indicator, they are looking for a short weakness.

Fundamental analysis

Fundamentally, there are several ways to identify short candidates, including poor earnings, lawsuits, changes in legislation and news. The key to using the fundamentals or news to trade stocks on the short side is to make an informed decision as to whether the event occurring is a short-term issue or a long-term event.

A negative news event is most likely to cause a rise in a market and not necessarily good long-term decline. In this case, the rise was most likely caused by stop loss orders that were activated. A long-term decline may start with an uptrend, but is most likely triggered by a series of negative events that give traders confidence that a long-term downtrend is developing.

An example of a rally caused by a news event is when a company’s earnings are reported lower than the consensus. Traders respond by selling the stock. However, a series of negative earnings reports is the type of fundamental factor that often attracts the short seller.

When an event is significant enough to crack the support of a market, volatility will often increase as nervous long traders begin to feel the pressure of the short sellers trying to drive the market lower. This is when a merchant can use both types of analysis to determine the severity of the decline that is in the store.

In general, a negative news announcement is often accompanied by high volume and wide ranges, as short-selling pressure builds in an attempt to drive the stock to technical levels that will trigger more sell stops. The short seller, driven by the confidence of the negative fundamentals, continues to try to push the market through support points, making it painful to hold on to long positions.

Short Selling in Action

Heavy volume, wide ranges and lower closes often catch the eye of short traders. Upon further investigation, the short trader will decide that the news event or fundamental is strong enough to cause a liquidation of long positions. These conditions may encourage short sellers to initiate new short positions.

A good example of this type of setup occurred in early 2007 in the S&P Financial SPDR Fund (AMEX:XLF). Figure 1 illustrates how short sellers identified a potential opportunity and used negative evidence from technical and fundamental analysis to take control of a falling market.

Figure 1 (Source: TradeStation)

Short sellers saw volume increase and eventually cause a downward acceleration.

After a long move up and a series of higher tops and higher bottoms, the RSI and stochastic indicators reached overbought levels. This was enough information to make traders think that a top was forming, but not enough to attract any selling pressure, because during the upward movement the same oscillators indicated possible tops.

The XLF provided the first hint of a top on February 20, 2007 at 37.99 and began its breakout to 34.18 by March 14, 2007. This move was the biggest downward move in terms of price and time that the market has seen since then. 2004. Compared to previous breaks, this move was much more severe, which was an important clue that the XLF was at the top, seen in Figure 2.

Figure 2 (Source: TradeStation)

The severe break during February and March gave a clear indication that XLF was winning.

While technical factors may have identified a possible top, news stories helped traders gain confidence in the short side by providing the market with negativity. On February 26, 2007, former Federal Reserve Chairman Alan Greenspan warned of a recession by the end of 2007. The next day, the Shanghai Composite Index fell 8.8%. European stocks also saw big one-day declines, with the Dow Jones Industrial Average (DJIA) falling sharply.

During the course of these broad market disruptions, XLF also attracted short-selling pressure as bearish traders interpreted this as a sign that a recession could potentially cut future earnings from financial institutions.

The first move down was caused by a combination of technical and fundamental factors. This provided clues to traders that the XLF was sensitive to the news which had a potential impact on futures earnings. It also identified price points in the market that may have been defended by long traders. During February and March, several subprime companies were reported to have filed for bankruptcy. This news, along with Mr. Greenspan’s comments most likely contributed to the decline in XLF from February 20th to March 14th.

As the market formed its top in early spring, more fundamentally bearish data was released, painting a grim picture in combination with the weakening technical setup. In early April, New Century Financial Corporation filed for Chapter 11 bankruptcy protection. While this news may not have caused an immediate disruption in the market, a bearish fundamental trend has begun to form, combined with the subprime bankruptcy filings in February and March.

XLF showed a downward price trend throughout the spring and summer. During this period, short sellers likely gained confidence from the unfavorable fundamentals, news reports and the visibly bearish chart patterns. Short sellers were likely encouraged by the negative news stories that spread pessimism among investors. Meanwhile, the technical patterns on the charts continued to confirm the downtrend with a series of bottoms and bottoms seen in Figure 3.

Based on the combination of the technical and fundamentals, it was clear that the short sellers were in control of XLF.

Figure 3 (Source: TradeStation)

The series of lower tops and bottoms indicates a clear downward trend through the spring and summer months.

The Bottom Line

In summary, to be a successful short seller, one must be aware of the cues presented both technically and fundamentally. Technically, the short trader must be able to distinguish between a top layer formation and a change in trend. They need to learn the types of formations that indicate a short-term top or a long-term trend.

Fundamentally, the short trader must distinguish between a one-off news event and the start of a series of negative events. By learning how both the technicals and fundamentals work together, a trader will gain confidence that can help one comfortably go short in the market.

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