Trading 101: Recommended Reading - ‘How to Make Money Selling Stocks Short’
I just finished reading William O’Neil’s book ‘How to Make Money Selling Stocks Short‘. I was rather surprised at the approach O’Neil professes. Given that he’s such a proponent of using both technical and fundamental analysis when buying stocks, I expected him to do the same for short selling. That’s not the case at all, in fact the book doesn’t even mention fundamentals (which is fine by me). O’Neil’s shorting method only takes the general market direction and stock charts into account. That shows the importance of the ‘M’ (market direction) in O’Neil’s CANSLIM.
The book is a very quick read. It actually was released in pamphlet form back in 1976. O’Neil and Gil Morales updated it with many charts and examples from the recent bear market and the years between 1976 and now. Less that 40 of the 192 pages are textual, the others contain annotated charts of “models of greatest short sales”. There are certainly more than enough examples for the reader to get a good understanding of ONeil’s methodology.
The first chapter is entitled ‘how and when to sell stocks short’. It begins by giving an explanation of short selling. (I even learned something here — that you don’t pay margin interest on shorts.) The bulk of that chapter discusses how tops are formed and how to identify them. I found the ‘what to sell short’ section especially interesting. O’Neil suggests shorting the the big leaders from the preceding bull market. One important characteristic to look for is a huge amount of institutional sponsorship. Those institutions may represent a ton of supply of stock. He also warns of what types of stocks not to short.
Probably the most important section of this chapter is the part about timing your sales. A key part of this methodology is the recognition that tops take time to form. O’Neil says that often the ideal shorting point is ‘five to seven months after the absolute peak in the stock’. He recommends using the 50 and 200-day moving averages as timing tools as well as some chart patterns to look out for. There’s also a discussion of strategies for closing out short sales. I found it interesting (and curious) that he didn’t cover his 8% stop-loss rule in this book. All he says is that your profit objective should be double your stop loss target.
The next chapter, ‘Anatomy of a Short Sale’, prepares the reader for the onslaught of charts in the final chapter. It contains two diagrams which lay out the key things to look for in stock charts. After finishing this section the reader should have the theory of O’Neil’s methodology down pretty well. The final chapter, ‘models of greatest short sales’ turns that theory into reality by giving over a hundred examples of real-life stock charts. That chapter begins with a detailed textual walk-through of several charts, including Cisco (2000 - 2001), Lucent (2000 - 2001), Calpine (2002), Yahoo! (2001), Broadcom (2001) as well as some examples from 1970. The rest of the chapter contains the aforementioned annotated charts. There are examples of stocks from the 1960’s all the way up to September 2004. Some of those 2004 examples are Krispy Kreme, NetFlix, Sina, Netease, Corinthian Colleges and Career Education.
Clearly O’Neil is on to something if he can find examples spanning 40 years. As I read the book I kept getting ideas about specific stocks and sectors to keep an eye on for shorting opportunities (the housing sector, ANTP…). There are a couple of important things that I took away from this book. I’ll often identify stocks that are topping but then I’ll get tired of watching them thrash around for weeks. I usually end up taking them off of my watchlist and subsequently missing some great shorting opportunities. It’s clear that I need to keep a longer term list of potential shorts. My other take-away is that I need to look at weekly charts much more often. The book uses weekly charts almost exclusively. Given that these tops form over months, weekly charts make more sense than the daily charts that I typically use. I’m looking forward to seeing if I can find some good shorts using O’Neil’s methods.
This post has 7 comments
January 2nd, 2005
Quite interesting
January 3rd, 2005
Looks interesting. If the emphasis is on market direction, the market is usually either going sideways or up. Of course, for two years it went down, and that was when you should have shorted Cisco, Sycamore, etc. Here’s another question: if you have an 8% stop loss and and a 16% target, it is very easy to imagine a volatile stock that goes down 50% but the short loses money because he is stopped out so many times. The arithmetic is not in your favor: from $10 to $5 is half as profitable as $5 to $10.
January 3rd, 2005
You could have the exact same scenario (getting stopped out and missing the move) for longs. And yes, you can obviously make greater percentage gains going long than short but that fact does you little good in a bear market and/or a stock that’s sinking.
January 3rd, 2005
Of course you can get stopped out going long, but stocks don’t tend to be more volatile on the way down than the way up. And it’s true that it’s no good going long in a bear market, but most markets either trend sideways or up. There are far more up 20% years than down 20%. Of course, if you trade over a timeframe of a few days, short or long is pretty much the same. It’s been my experience, though, that it’s much harder to identify shorts than longs, with the exception of 2001 and 2002, which was a far from typical market.
January 3rd, 2005
I don’t agree with a blanket statement that says stocks are more volatile on the way up than on the way down. One could find plenty of examples to support the opposite argument.
I look at the market this way — it goes up sometimes, sideways some time and down some of the time. Identifying the direction depends a lot on what time frame you’re considering. A year-long sideways move may be twenty up moves and twenty down moves. Take the current market for example, I could say the NASDAQ has just been going sideways since 1999 when it was around 2150. But there have been great long and short opportunities .
Just as there’s always a bull market in some sector or stock, there’s always a bear market somewhere. Given that I think it makes good sense to search for all money making opportunities be they long or short.
January 3rd, 2005
Have you calculated your results on shorts versus longs? Longs have been much more successful for me, for the simple reason that I have a few triples on the long side but none on the short side. Just by virtue of the fact that shorts tend to be crowded with shorts tend to make them more volatile because susceptible to squeezes. Add to that the unfavorable arithmetic and I’ll stick to the bull markets.
January 3rd, 2005
I agree that longs are easier to trade for various reasons and can be much more profitable. If I had to choose just one side of the market I’d choose longs. But since I don’t have to choose…