Feb 4: Part 3: The Simple (Basics of Stock Trading) – Trading with the Trends – Short Selling

by David Jenyns on February 4, 2006

In both rising and falling markets, stocks can become targets for shorting as a result of trends. Short selling is always a stronger strategy during a bear phase, but many short selling plays work extremely well in bull markets. In fact, some shorting opportunities don`t even arise in bear markets because many shortable trends are the after effects of buyable trends.

An example of short selling is the reliable trend of weak stocks falling after they have run up on moderate news. Let`s say the biotech sector has been hot during the last couple of weeks.

Then a small pharmaceutical firm puts out a news release that its new drug has passed its trials and will soon go to market. The market`s perception of the news is extremely positive, and the stock rises 30% in two days. Your analysis says that the price won`t hold at that level. So you wait for what you believe will be the stock`s final push upward, short it near the top, set stops to protect yourself, and wait for the stock to fall.

Stocks like this that rise on news can be traded during both parts of their journey; long on the way up, and short on the way down. They`re ideal for trading because once you`ve watched a few similar situations, you`ll get an idea of just how far the market is willing to push them up.

Adding a stock to a major index is another trend that creates a strong upward push on prices. Mutual funds that track major stock indexes have to buy any new stock added to an index in order to keep pace and follow its investment guidelines. The larger the market capitalization of the company added to the index, the more shares the funds need to buy. The increased buying pressure on stocks added to indexes tends to drive their prices up, creating a great trading opportunity.

The stock may or may not begin to move on the day the index addition is announced, but it generally starts to move up in earnest one to two weeks before the addition actually takes place. Once the stock enters the index, its price tends to fall as traders take profits. Remember, traders always sell on news. The stock can fall for several days after it`s been added to the index. Short selling allows the trend to be traded long on the way up, until the day the stock is added to the index, and short on the way down, after it`s been added.

Mutual funds are the source of other profitable trends for traders. At the end of each quarter, mutual funds try to dress up their portfolios by buying the stocks that have had the best performance during that quarter. They do short selling to mislead potential investors into thinking that the fund`s managers are great stock pickers. For example, if semiconductor stocks did well during the quarter, funds may load up on them during the last week of the quarter so their `holdings` list will give the impression that they have made wise trading decisions. It`s completely superficial, so it`s called `window dressing.` It`s possible to make money on this short selling trend by buying shares of high performing stocks just before the end of the quarter to catch the price rise when funds start buying large quantities.

The flip side of the short selling window dressing is that funds often dump their poor performing stocks, stocks in any group that`s under performed during the quarter, right before the quarter ends. You can try picking up stocks in under performing sectors at the end of the quarter, because they`ll often be picked up again during the next quarter by the same funds that just dumped them. The funds still want the stock, but they don`t want to reveal to investors that they owned so many underachievers, which gives savvy traders a nice opportunity to profit.

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