A Fundamentals Approach to Shorting Stocks

from  (published March 2006)

 Richard W. Miller, Ph.D.

           The market is up one day, down the next. Further, we’re rapidly approaching the bad six months in the market’s half-year cycle. On the one hand, most of us prefer to trade long fundamentally sound stocks. On the other, there’s a problem. We’re rapidly approaching a period when our long picks likely must perform against the market, swim against the current if you will. The biannual cycle is well tested and its reasons understood (see Yale and Jeffrey Hirsch’s “Stock Trader’s Almanac”). You need to be aware because its impact is dramatic. From 1950 through 2005, if you had segregated two, $10,000 accounts, investing one exclusively in the Dow between May 1 & Oct. 31 and the other in the Dow between Nov. 1 and Apr. 30, the first would have fallen to $9,728 while the second grown to $499,981. Chart I shows the daily median close for the last seven years, i.e., the mid daily close for the seven components. The arrows highlight biannual periods.



Trading long over the coming six months is apt to put the wind in your face, so to speak.  Given that environment, how does a fundamentals trader respond:  by not trading, by trading fewer shares, by honoring tight stops, by hedging with options, by taking profits more quickly, and by trading short, i.e., borrowing shares, selling them today then buying them back later.  This last is what I want to talk to you about today.

Perhaps William O’Neil said it best in “How to Make Money Selling Stocks Shorts,”  “It takes real knowledge and market know-how as well as lots of courage to sell, and particularly to sell short, because you will make mistakes.  However, I don’t see how anyone can really do well in the market and protect assets if they don’t learn how, when, and why stocks should be sold.”  Amen.  Let me share the TripleScreenMethod’s (TSM) approach with an example.

When the market environment turns bad {biannual cycle and two market measures, the sentiment product (2/06 News), the “amazing 200” (12/05 News}, TSM looks seriously at identifying potential shorts, not exclusively, but perhaps matching its number of long candidates.  TSM’s long candidates are based on superior fundamentals, upward earnings revision fuel, value, and technical pullback criteria.  Conversely, TSM short candidates are based on inferior fundamentals, down-ward earnings revision fuel, overpriced value, and technical recovery into areas of resistance.

Consider Kos Pharmaceuticals, Inc. (KOSP).  On 12/15/05 it had a massive sell off on comments by Merck that potentially could impact KOSP’s major product.  A few months later, on 2/23/06, it gapped down on a company warning of reduced 2006 expectations, well below what analysts expected for the year.  Over the past 90 days, its 2006 earnings estimate had dropped 28.4 percent from $3.27 to $2.34, and this year’s PEG (price-to-earnings-to-earnings growth) was –0.87 due to its negative growth.  Fundamentally, KOSP was a good short candidate.


Technically, KOSP was developing a well-defined zone of resistance (shaded area), i.e., an area where its price repeatedly reversed down (in Dec. of 2005 and Feb. this year).  Further, Dec.’s wide-range candle provided further resistance as lots of people buying the big drop awaited their chance to get out at breakeven.

The ideal short point occurred as price approached the shaded zone.  TSM started following KOSP on 3/14/06.  The inserted candle pattern highlights the trade that developed on the 21st as price fell below the low of the previous day (the short point).  The first profit target was set at the prior multi-candle low.  Notice how this area supported price for three days before finally breaking through to the short point.  Five trading days later, price had reached our first profit point, and 1/2 the position was covered for a $1.50 gain (3 percent return).  The 2nd half of the trade exit will be covered through a 2-day trailing stop, i.e., when today’s high exceeds the higher high of the last two days.

Like the long trade, one wants to hit the first technical target, take profit from a portion of the position, then stay with the trade as long as possible with the 2nd half.  Of course, the trade would be protected by a 7.5 percent stop of last resort before the profit point was hit.  If KOSP had recovered to $53.52 at any time over the duration of the trade, the entire position would have been covered. 

The common knock on trading short is the liability incurred as the price climbs.  That’s protected with sound trade management strategy as easily as the liability of a falling stock price is protected in a long trade.  When the market turns down, consider hedging your portfolio with a few short positions.  Note, I usually trade half the size going short that I do going long and freely admit that short trading is more difficult.