8 Reasons Why Not to Sell aStock ShortSelling Short requires more skill than going long. Thatstatement alone may trigger a response from my readers, but Ibelieve that is an accurate statement for a number of reasons.

First, the market has a bias to the upside, as most marketparticipants buy and hold stocks. Secondly, depending on howyou hedge your trade, you in theory have unlimited risk ofloss when shorting. This concept of unlimited loss presentsmore complexity in terms of money management and how that isincorporated into your trading methodology.

In this article I will cover 8 reasons of why a trader shouldavoid shorting a stock. These reasons have been grouped intothe following three categories: (1) technical, (2) moneymanagement and (3) psychological. At the end of this articleyou will be able to identify any red flags when it comes toshorting and your trading approach.

Technical AnalysisIn the first section of this article I will be covering thetechnical signals of when you should avoid taking a shortposition. Most of these signals will center on movingaverages as these are great trend following tools.

#1 Do not short when a stock is above its30-week moving averageI actively use the 30-week moving average as an integralcomponent of my swing trading strategy. I would love to takefull credit for coming up with the 30-week moving average as atrend following tool; however, that accomplishment solelybelongs to the great Stan Weinstein. To read more on Stan and

the 30-week moving average, please check out his book titled‘Stan Weinstein’s Secrets for Profiting in Bull and BearMarkets‘.

The 30-week moving average provides the line in the sand forlong-term investors that use weekly charts. Essentially the30-week moving average provides the same information in termsof bull or bear markets as the 200-day moving average fortraders that use daily charts.

Below are a few examples of weekly charts and their 30-weekmoving averages. Please take a minute and go through eachchart and identify which stock is in a bull or bear market.

Is Tesla in a bull or bear market?

Is XOMA in a bull or bear market?

Is IWM in a bull or bear market?

First Tesla, based on the strong uptrend, healthy1.corrections after new highs and the stock holding aboveits 30-week moving average, TSLA would be classified asbeing in a bull market. (Bull Market)XOMA had a significant break below its 30-week moving2.average and now has slipped into bear territory afterthe spring 2014 crash of small cap stocks. (Bear Market)iShares Russell 2000 Index Fund ETF (IWM) while below3.

its 30-week moving average has not broken downconvincingly. Therefore, the verdict is still out onwhat direction the ETF will take. The one determinationyou can make is the ETF is weakening as it tested the30-week moving average in February, only to retest theaverage again in early April. Once a security begins totest and retest their 30-week moving average withinshort timeframes, control is likely shifting from thebulls to the bears or vice versa. The key thing towatch for XOMA in the coming weeks is if the ETF is ableto make a new high. If the ETF fails to make a new highand then breaks below the 30-week moving average again,we can safely say the market is now in corrective modeafter the 2012 – 2014 bull run. (Trend – To bedetermined)

One thing I realized early on is that while the 30-week movingaverage is critical to my trading strategy, other traderscould potentially care less. This means that a stock may notturn on a dime at the 30-week moving average. There are timesthat a stock will penetrate the 30-week moving average, onlyto shake out weak longs and will then quickly rally.

Again, this is not an exact science, but more of a guidepostfor trading on a weekly basis.

#2 Do not short when a stock is aboveits 200-day moving averageThe 200-day moving average provides the same sort of line inthe sand for bulls and bears as the 30-week moving average. The difference with the 200-day moving average is theindicator is far more popular than the 30-week moving average.

Generally speaking, the 200-day moving average will lag the30-week as the 200 day represents 50 more trading days.

However, the same rules as identified for the 30-week moving

average are applicable for the 200-day moving average.

Again, I must reiterate that the stock may not turn on a dimewhen crossing the 200-day moving average, but you will want toavoid scenarios of going short when the stock is significantlybelow the 200-day moving average.

Using the below images, can you tell which stocks are in abear or bull market based on the 200-day moving average?

Are the bulls or bears in control of Apple?

Is Yahoo in a bull or bear market?

Do I even have to ask whether EXTR is in a bull or bearmarket?

Apple is clearly in a strong uptrend as the stock is1.approximately 15% above its 200-day moving average.(Bull Market)Yahoo is similar to the IWM example above where the2.bulls and bears are in a bit of a stalemate. (Trend – tobe determined)EXTR was in a 2 week battle at the 200-day moving3.average, only to gap down through the average with priceand volume. (Bear Market)

#3 Do not short when the stock is in aclearly defined uptrendMy definition of a clear uptrend is when the stock has higherhighs and higher lows for the last three consecutive swingpoints. While you can technically make money trading any typeof trend, it will be tougher to profit shorting a stock in aclear uptrend.

I know you are probably thinking, well if the stock is hittingthe resistance line, then why not sell the stock short toprofit on the pullback. This is a valid argument, but there

is always an undefined risk of shorting a stock in an uptrend.

A general trading rule is that whenever the market presentssurprises, they are likely in the direction of the primarytrend. So, if the market decides to gap through resistance orgo off script, odds are this anomaly will be in the directionof the primary trend.

As you can see from the above chart of E*TRADE Financial, ifyou would have attempted to short the stock while in thisuptrend channel, you likely would have been wrong far moretimes than right. It would have felt like pulling teeth toturn a profit. The grinding action higher in E*TRADE over thelast 18 months is a reflection of the shorts entering andexiting the market after each failed attempt.

#4 Do not short highly volatile stocksTrading highly volatile stocks is the key to making fast moneyin the market, assuming you know what you are doing.

In today’s market, the high flyers are the biotechnologystocks. These stocks will rally or fall on earnings reports orresults from clinical trials quicker than any of us can blink.

Below are a few charts of biotechnology stocks that rallied

hard after pullbacks. For me, it’s not necessary to introducethis level of risk into my swing trading strategy. There arejust far too many other ways to make a buck in the market.

So, to avoid the potential for huge losses, if you must tradevolatile stocks, only trade them on the long side.

#5 Do not short if the market is in astrong bull marketIf you see the market is in a strong uptrend, do not go outthere guns blazing shorting everything in sight. I knowcalling a major market top is like the unicorn for

technicians, but why not just ride the wave higher so you canmake money with the wind at your back.

Stepping in front of a strong bull market is a sure recipe tolosing your hard earned money.

Below is a chart of the iShares Russell 2000 Index Fund ETF(IWM) from late 2012 through March of 2014. Can you pleaseexplain to me why you would fight this level of bullishness?

Money ManagementTrading is not only about being right, but being right at theright time and having enough capital on-hand to weather anystorms. While the next few sections aren’t as glamorous asshiny stock charts, please do not discount their importance.

#6 Do not short stocks with strict marginrequirementsAfter the previous section on highly volatile stocks, it’s agreat segue to strict margin requirements. While you may feellike you are ready to take on the world, your brokerage firmmay think otherwise. These firms will provide strict marginrequirements for trading volatile stocks based on the level of

risk exposure they are willing to accept.

So, when you decide to short an extremely volatile stock, themargin requirements are often so strict that you arepractically forced to only use your available cash. If yousee that a stock has ridiculous margin requirements, it’sprobably best to avoid trading the security since it willgreatly reduce your ability to trade with margin.

Beyond just trading with margin, if you were to encounter anyof the sharp rallies like we just reviewed with thebiotechnology stocks, you will likely get a margin call. Thiswill force you to either add more cash to your account or youwill need to close out the losing position. Traders will say,well if the stock rises from $2 to $6 dollars, I will justwait for the pullback. This is true if you have enough cashon hand. Most traders are either over leveraged, which is whythese volatile stocks rally so quickly, because shorts areforced to liquidate their positions by their brokerage firmsto meet the margin requirement

#7 Do not short if you are using a goodportion of your marginEven if you are shorting blue chip stocks and the marginrequirements are relaxed (less than 35% cash required), youstill can get in over your head if you were to use 150% or thefull 200% of your marginable equity for shorting. Unlike longtrades, without a hedge, you essentially have unlimited riskwhen shorting. If you read this last sentence and are stillthinking to yourself, “What’s the big deal with using so muchmargin?” You are likely suffering from market greed and atsome point will completely blow up your account.

If you are using all of your available cash for trading, doyou think it’s wise to then use margin to place more money atrisk when shorting?

PsychologicalAt the end of the day, if we strip away all of the news,charts, opinions, etc. we are left with our belief system asan individual trader. If you do not have a winning attitude,don’t bother getting involved in this game. Below is the keypsychological question you need to challenge yourself on as itrelates to shorting.

#8 Do not short if you can’t handle theconcept of unlimited riskWhen shorting, you in theory have opened yourself up tounlimited risk unless you have hedged the trade. Now if youare ok with that fact, shorting will feel the same to you asgoing long in a stock. However, if you as a trader have notembraced the fact the market could continuously run againstyou, any rally will create an enormous amount of anxiety.

If you feel that you are unable to muster up the intestinalfortitude for shorting, it’s in your own best interest to stayon the long side of trading.

In SummaryShorting can be an extremely profitable means for trading themarket. I myself have and will continue to short the marketwhen opportunities present themselves. You just have to lookat the market through a different lens.

If you read a few of the above 8 explanations for why not tosell a stock short and it gave you reason to pause, then headover to our homepage. You can try shorting using our tradingsimulator to see if there is any merit behind your hesitation.

Good luck trading!

Al

Photo Credit

Stock Images courtesy of Freestockcharts.com