Basic Instructions for Shorting

Basic Instructions for ShortingPage 1 of 9

Basic Instructions for Shorting

Using ElliottWave’s Short Term Update[1]

Preface

The information contained in this document is subject to error. It is supplied in good faith and is not intended as a recommendation to buy or sell stocks. Use it at your own risk. It is not for the faint-hearted and takes a fair degree of good sense to apply its premise. It is incomplete and constantly revised.

If your principle goal is not to lose money then this information is not for you. You must risk loss at every juncture of these instructions. I have recently sat on paper losses in excess of a quarter of my entire portfolio. The first fiscal year of trading I lost all my gains and then some. Theoretically, the whole of your investment is subject to loss. Often I have read that an investor should be prepared to lose the entire sum. This is sound advice from a rational standpoint and it must be said. But, what is not so obvious is that investment philosophy most often has a paradoxical relationship to profits. So, while you are going to read the word “loss” again and again in this document the reasons for doing so are many and not intended as an obstacle to the process.

Further, in the line of philosophy, investing is not gambling. It is gambling if you treat those investments like a casino. In a sense you have to be both a technician and an artist to do well. A technician follows functional rules. An artist focuses on form rather than time and price. You must do both with wave analysis.

Elliott is only one of many approaches that have a proven track record of gains. This information can be used as a part of Elliott principles or in conjunction with other systems.

In February of 2002 Japan passed stricter laws on short trading (ref. August 19, 2002). This preceded a bottoming in the Nikkei. It is also possible that this occur again in the United States (e.g. Jan. 1980 Comex futures). However, such action is usually associated with market bottoms. In such a case it is probably time to be going long[2] on stocks anyway.

Finally, there is a sense in which this document makes the shorting process more complicated than it is in daily practice. It was only after I began shorting that I learned the details which this documents attempts to explain.

Definition

To short a stock simply means you are borrowing the stock from a broker at a certain price in anticipation of its price falling in the future. ElliottWave International foresees the opportunity for this strategy to be the overriding movement of the indexes during the remainder of 2002 and into 2003.[3]

The principle in shorting is that you are essentially borrowing the stocks from another owner, much like when you make a loan from a bank. The broker either has the stock in inventory or he borrowed it from a client at another brokerage firm.

In return for the broker letting you borrow these shares you are charged a nominal interest fee.[4] The difference in the price from the time you borrow the shares and the time you return the shares to the borrower is your profit – or loss.

This document does not cover futures or options.[5] One of the principle reasons for this is that shorting a stock allows for errors in timing. Futures and options are more precise instruments with greater profit potential but require a greater level of expertise to manage potential losses.

Allowing you to use someone else’s shares implies a couple things:

1. The stock must be available to borrow and you may be required to return the shares at a loss. You may not be able to retain them indefinitely especially if the demand for the purchase of the stock is high. For the most part, however, brokerages do not place a time limit on the stocks they loan because a.) They make a commission either way, and b.) They want to keep their customers happy.
2. The short interest rate depends on the stock and whether the stock is trading on margin at a profit or loss. Wall Street Journal or Investor’s Business Daily have lists of rates corresponding to the stock symbol. STU is, as the name implies, short term. However, you may need to hold a position through a correction[6] that can last weeks or even months.
3. You must have a margin account[7] to be able to short stocks. The stock itself must be marginable and shortable. It is best to short on equity, not margin – especially during corrections. If the price continues to rise and you are trading on margin you may get a margin call and be required to do one or more of the following: a.) Deposit more cash in your brokerage account or b.) Return some of the shares to cover the brokerage’s margin requirements.
4. I found out this one the hard way. If you hold a short position then you have to pay out cash to cover dividend obligations. This obligation arises because the original owner of the stock (i.e. the individual or institution from which you have borrowed the stock) would receive a dividend payment if they had not lent you the stock. Because you have sold their stock to another party, this other party receives the dividend that accrues on the ex-dividend date. As a result, you have to “make-up” dividend payments to the original stockholder during which your short sale is outstanding.

The Process

To borrow a stock in this way you place a “sell” order first for the number of shares you want to borrow. Most online brokerages give a summary of the transaction before it is placed and thereby let you know that you are intending to short the stock. Although the logic of beginning the transaction with a “sell” seems convoluted remember, you are attempting to purchase at a higher price – usually the point where an owner would want to sell it. Also, you are truly selling it. You are borrowing it from your broker and then selling it to another buyer. Your broker arranges this and it is transparent to you.

Then, assuming the price falls to a level STU anticipates, you return the stock to the broker with a “buy” order – the usual low-price point at which a long trader buys shares. Again, the difference between the price of the stock when you borrowed high and returned the shares at a low is your profit.

Strategy

Study Elliott Wave theory. Purchase Elliott Wave Principle by Prechter and Frost. It is essential to understand its fundamental structure. To intelligently participate in nearly any study of trading you should know wave theory because waves are commonly discussed. It is not necessary to know precisely where you are in the developing waveform so long as you understand its position relative to its larger context. The better your understanding the better your profits and composure in the inevitable maelstroms that can occur.

Take strategic losses. There is a difference in being wrong and staying wrong. For example, you could, theoretically, hang on to your stock during an upward correction in an overall deflationary[8] period. While you’d like to think that you rarely, if ever, sold at a loss this is usually counterproductive for the following reasons:

1. If the stock rises above Elliott’s initial resistance levels and appears to be tracing out a higher Fibonacci resistance then it stands to reason that your profit will be greater if you sell at the loss and regain it by shorting the stock again once the higher resistance levels draw closer. Yes, you will be purchasing fewer shares at a higher price but the gains usually outweigh the reduction in shares being leveraged.
2. You are sidelined, possibly for a long period of time: corrections sometimes take weeks, even months. You could have recovered the loss by shorting the unexpected spike in prices. Also, being sidelined reduces your learning experience. We learn principally by doing. When you just watch the market the experience is less educative.
3. The psychological effect of watching an upward correction press a 10 to 20% loss can be debilitating. Corrections since the index top in 2000 have registered in the 20% range before declining in earnest again.
4. I have read that most professionals have three losses for every gain. They have, however, learned how to minimize the loss,[9] free up that “dead” money, and employ it elsewhere for immediate gain. Obviously, if you are not a nimble this is not a good strategy.
5. There is a slight potential, even when not using margin, that your broker could ask for the shares you borrowed back.

This does not mean that you accept a loss under every circumstance. It is a general principle. If you prematurely short “up to your eyeballs” then this loss may be too debilitative and counterproductive. The trend will eventually erase the loss. In such a case wait it out.

Stay with index stocks reflected in the Short Term Update. Until you gain experience in wave theory it is wise to stick with the indexes covered in STU. Below is a list of corresponding stocks that are typically used as proxy trading instruments for these indexes.

Align yourself with the main trend. Currently this is hard down. Surprises in a bear market are to the downside. So be very careful when trading long on an index correction.

Use stops to cover gains, not losses. Some online brokers allow you to use trailing stops to keep you close to current point or percentage levels. I do not use stops to cover losses. Why? Well, for one, after hours trading can be vicious often targeting stops for profit. If you can keep an eye on your trades during the day then do so without stops. When you set a stop it will, on occasion, be targeted. Another reason I do not use stops to cover losses is covered in the “When All Else Fails” section below.

Short at the top of channels – Go long at the bottom. Channels (EWP[10] p. 69) serve as guideposts for the expected limits of a stock price movement in time. Trade with the slope only. Simple trades are always better. Generally, keep your long positions in the current market short in duration. Note, however, that channels typically break down after a few weeks or even days. Though once identified early they are good indicators of near-term direction.

Avoid market orders. When I have elected to purchase at market I usually get take a small loss on my entry or exit gains. Use limit orders whenever possible.

Stay glued to STU – even when it hurts. More often than not this results in greater gains. I’ve only lost when I abandoned it altogether and did what I was advised not to do.

Trade on equity, not margin. By “equity” I mean the cash value of your account. Cash is a far safer vehicle and has the added benefit of allowing you to sleep at night. The first time I traded on margin was an error, an error that fortunately turned to my benefit and, hence, allowed me to see the virtue of the practice. However, my policy to practice this is currently restricted to 3rd wave declines in a bear market and 3rd wave advances in a bull.

Use your head. If you are tired, have just been through a debilitating emotional experience, are sitting on an untenable position, are in a hurry, etc. that is just not the time to make a decision. For example, I’ve seen even the most stalwart and experienced traders wilt during a correction. In this example you must, by virtue of the process, operate on faith. Faith is not a hope that things will go your way. Faith is a conviction that belies appearances and is welded to facts. Appearances are often paradoxical to reality. Faith discerns between these opposing components: the seen and the unseen.

Do the math. Most uncertainties are avoided by keeping charts on both arithmetic and semi logarithmic scale.[11] More importantly, spend a good deal of time with Fibonacci resistance levels. They are probably the most single important tools for short-term analysis.

Patience. W.D. Gann has done very well and advises to sit it out. The trend is your friend. Once identified you buy into it during its entire tenure.

Wave 2 blues. This goes with the previous advice to sit things out. Wave 2 movements are sometimes called “terrible twos” because they whipsaw up and down. It is particularly important to exercise patience here. You may be sitting on a position for as long as a month or two during wave 2. That’s OK.

Seasonal bias. May begins what is known as a “seasonal bias” wherein the market enters its “weakest” six months of the year, with November-to-April being the “strongest” six months.[12] A dump in June usually follows a “Sell in May.” Further, there are positive seasonal tendencies in the market around the last few days of an old month and the first few days of the new. But this is not to say that seasonal biases are always consistent with wave patterns or larger cyclical forces. Seasonal biases can easily be swept aside by these and other factors. Nevertheless, it is important to recognize this predisposition of seasons and work with it. Note that when the end of a bullish seasonal bias produces lower highs than the bearish seasonals it portends a protracted decline.

Counter Arguments

I keep my investments close. It’s a private endeavor. In my reading, however, I’ve seen quite a few references to the problems attendant to this system. Also, it is unavoidable and usually necessary that a close friend or spouse understand the counter arguments involved.

Limitless losses. Recently a Reuter’s financial writer posed, “It’s a risky world. While those who buy stocks stand to lose only as much as they’ve invested in a worst case scenario, there’s no limit to the losses short sellers can incur because shares can keep rising.”

To this I answer, “True.” If you shorted a single share of a $10 stock then the stock soared to $100 a share you would lose your ten dollars and have to pay $90 to your broker’s account. But let’s go back to our casino analogy that began this article. This Reuters analyst’s premise is that of an investor who is treating the market as if it were an entertainment vehicle. This happy-go-lucky fellow puts his money into a stock slot machine and pulls the lever hoping his luck is right. Throughout this article I have provided technical procedures that eradicate this nonsensical assertion.

Turning the argument I’d ask the Reuters investment professionals to answer the following: Why did four stocks chosen by a random throw of darts nearly beat the average loss of 4 stocks chosen by investment professionals as reported in the Wall Street Journal?[13]

Further, the argument presupposes that valuations always rise; that periods of predictable and sustained devaluation rarely, if ever, occur. The blunder in this assumption is obvious.

It’s gambling. Following on the heels of the above objection is the protest that such investments are gambling. This would be true if you were betting on an uncertain outcome or playing a game of chance for stakes. But rational investments of any kind are academic exercises that, in most instances, virtually eliminate the venture as “betting” on an uncertain outcome. Even when losses do come they are nearly always recoverable by a reassessment of strategy. Also, the pleasure aspect is nominal when hour after hour you are pouring over charts and other technical instruments to govern your approach.[14] Further, bringing the argument to its logical conclusion, nearly all endeavors involve risk of some type. In every such decision we weigh the risk against the perceived benefit and make a reasoned decision. Marriage is a classic example. One might argue matrimony as the worst gamble of all. Yet few are so gallant as to call it gambling.

There is some support among professional investors for occasions when the market is in what is called “casino mode.” That is, a bad market that allocates money to the wrong projects. It is probably not a good use of terminology. It would be better to make the analogy of a sincere businessman who starts a company that is poorly timed and poorly executed. The effort is not a gamble strictly speaking, just a poor investment.

Still others argue that investing is an attempt to maximize dividend payments over a long period of time by assessment of value in a company’s stock. Trading is an attempt to gauge value in close technical measures without as much regard to the alleged value of the company. Neither are analogous to betting.