A Process for Finding Short Sale Candidates

The analysis of short sale candidate is the same as for long ones.

Bull and Bear
The process to find short candidates. Photo Credit: Andrew Unangst/Photographer's Choice/Getty Images

The short-selling process is no different than trading from the long side. It is your responsibility to define a set of criteria / metrics that puts the probabilities in your favor...stacking probabilities.

The following are some of the criteria that factor into my selection process for a short candidate. Please note that I am not talking about shorting ETFs, only stocks.

Market Trend

In an uptrending market I see little value in taking on short positions.

The trend is not in your favor. If the market is trendless or downtrending then you have the environment to short.

Liquidity

I do not short stocks that trade less than 200,000 shares a day. I do not want to get trapped in illiquid situations if the trade goes against me.  Based on my short trades over the last seven years the average daily volume has been around 400,000 shares a day.

Price

I do not short stocks with a share price below $20. The less shares I’m short the better.

Moving Averages

I do not short stocks when the 200-day moving average is trending higher. I look for stocks that have a 200-day moving average that is flattening or even better, declining. One of the reasons why the drop in 2008 was swift and of great magnitude was that many of the stocks had a 200-day moving average flat or trending down. William O'Neil discusses (“How to Make Money Selling Stocks Short”) how the optimum short point comes 4-6 months from the high.

In many cases, it is 8 to 9 months. I often turn the chart upside down and read it from right to left to get a clearer view.

Industry Group Rank

I am not looking to short stocks within the lowest ranked industry groups, because most of the stocks have already traded below their sweet spot. I target industry groups that have dropped out of the top rankings with notable acceleration.

Industry Group Leader or Not

I do not short the stocks that were the industry group leaders. Often traders are still trading them, playing the swings on an intra-day basis. I don't like the volatility and it can force you out of a position very quickly.  I target the stocks that barely participated in the group strength...group laggards.

Industry Group Developments

I will not consider shorting a stock that is in an industry group that has been the subject of merger rumors. Headline risk can be position killer.

Price Direction

I always try to short the stock when it is moving higher. Often when a stock breaks a key support area it will recover that price level almost immediately. Institutions use those support levels to add or initiate positions. I try to short as a stock trades up into resistance. It could be a price resistance area, major trendline or moving average.

Short Interest

Not a deal breaker, but I tend to avoid stocks with large short interest. For me, the threshold level is 10% or more of the float.

Company Fundamentals 

I like to briefly review the earnings surprise history, estimates trend and any new products or management announcements that could positively affect the stock.

Conservative Profit Targets and Tight Stops

I tighten my stops to 5% from 8%.  If a short position shows a gain of 15% or more I’m looking to close the position.  If the position is selling off very quickly I may put that short position aside and give it some more time. In 2008 I gave a few stocks more time. It allowed me to capitalize on several major declines in emerging market stocks.

My recommendation when short-selling is to keep your expectations low, accept a lower batting average and smaller average gains, and always use tighter stops and always keep probabilities on your side.