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How to Profit from Vertical Shorting

April 25, 2016 by Lior Alkalay 4 Comments

It’s not hard to decide if the trend is up or down. But have you ever noticed that sometimes the momentum is so intense the trend almost seems vertical? Kind of like the pair is falling off a cliff or ascending like a rocket?

The pair moves hard in a very short amount of time. I like to call those types of swings “vertical trades”, whether long or short. In this article I intend to focus on my personal favorite, vertical shorting.

Basics of Vertical Shorting

Before delving into the technicalities, it’s always wise to first understand the fundamental mechanics behind a trade. First, what causes the market to move in a vertical short? It is a sudden wave of sellers that overwhelms the buyers so much that nothing can stop them. The pair, rather than moving lower in waves, moves lower almost in a vertical line.

Spotting the Vertical Short

It’s often true that when the market move down in a vertical manner, shorting at the right time is impossible. Very often, something unexpected has happened. That generally is what leads to a sudden wave of selling. Sometimes, it is a set of economic indicators which have surprised the market. Then, a massive short selling wave begins.

On occasion, the piling up of massive short selling is evident just before the burst. And when that happens, it’s the ideal time to ride. Just start shorting and wait for the vertical short to do its thing.

What we can see in the EURUSD chart below is what I consider the ideal pattern for a vertical short. That’s simply because it’s perfectly evident and easy to implement, even for traders without years of experience.

What are the evident signs? At the beginning of the trend, marked with point A, we can see a regular bearish trade. But, as we move to point B, something quite interesting happens. There is a new sub-trend (marked in blue) with a steeper angle. As we can see, the ensuing waves, rather than reaching the red line at the peak, tend to top out much lower.

That is our sign that a vertical trend is coming. Going back to the basics, it can mean only one thing. That is that the volume of short selling is overwhelming the buys. Soon we will have a vertical, falling off a cliff sort of selloff.

Shorting

When to Start Shorting?

Just like any trend, timing the exact phase in which you should begin shorting is important. With the right timing, you can maximize your profit and minimize your risk. Some might presume that the right time would be the break of the lower trend line. But that’s not always smart. Usually the break of the lower trend line is so abrupt that, by the time the break is confirmed, the market has moved too far off. Then, you might find yourself risking much more to profit much less.

However, if we had started shorting at point C, we could put a rather close stop loss (i.e. risking little) and bank on that vertical short. How would we spot our next point C? My rule of thumb is this: the third time the pair tops out (at our new blue trend line) that’s the confirmation that a vertical short is imminent.

Now, that doesn’t necessarily mean that the pair will fall off a cliff right afterward. However, the pair is likely to continue to slide lower anyhow until the burst. So even if the “spark” comes a bit after we are already banking on profits.

Stop Loss for Dessert

Finally, before we begin shorting, we need to talk about your stop loss. It’s important to put your stop loss above the higher red line and not the blue line. This way, even if the massive short selling we’re counting on doesn’t occur, you won’t be thrown out of the trade. If the pair resumes its old slower trend you could still make a profit, albeit at the much slower pace.

As I like to point out, nothing is guaranteed and many times vertical shorts don’t show clear signs. But if they do, you should know how to take advantage of them.

Filed Under: How does the forex market work? Tagged With: short strategies, trend

The Beginner’s Guide to Short Selling

December 11, 2015 by Lior Alkalay 10 Comments

Short selling is easy, right? Basically, it’s the same as buying, only going the other way. At least that seems to be the common belief when discussing shorts.

In practice, taking a short position is rather simple. However, it’s also utterly different when it comes to an actual strategy. Because, like it or not, shorts do mirror longs, absolutely and completely. And to be a really good short seller, you must know the difference. You must also know how to optimize your strategy specifically toward it.

Short Selling is Fear-based

When you short sell you gain when the instrument you’re trading moves lower. That’s the exact opposite of when you’re long, or a buyer. And that’s where the similarities between long buying and short selling end. You see, when a trader buys or goes long on something they’re betting the outlook for that instrument will brighten. And the instrument doesn’t matter, whether it’s a stock, or a commodity, or even an index like the S&P500.

As a side note, however, the case in forex is a bit different when there are currencies of the same status. For example, say the pair is comprised of the dollar and yen, which are both safe havens. But when it comes to say EUR/USD, EUR/JPY or GBP/USD, shorts on those pairs are still driven by fear.

But when traders sell? Now, notice the nuance, it’s not short sell, i.e. make money from a falling price, but actually selling. When a trader sells a position he or she is doing it out of fear of losing money. And it doesn’t matter if that selling is taking profit or trimming losses, it’s still driven by fear. When you’re short selling you’re basically trying to profit from the fear.

Fear, however, works differently than optimism. You see, fear tends to come and go quickly. You can liken it to a stampede of investors running from a predator.

That’s not speculation; that’s fact backed by years of data. Take a look at some of the harsh short selling events in the chart below. You can clearly see that gains that took more than 8 months to achieve were wiped out in less than 4 months.

Short selling

Source: esignal

Why is that important to you as a short seller? Because it reveals the exact nature of shorts; quick and abrupt. As such, the strategies warranted for such movements should be designed accordingly. In other words, built to ride on quick and abrupt momentum for a quick gain and then closed. True, there are abrupt moves higher, as well, and matching momentum struggles. Momentum should be in the DNA of every short selling strategy if it is destined to succeed in the “long run.”

Starter Kit for the Short Seller

In order to be a successful investor you must be ready for a high momentum short time span trade. And of course, it’s all relative to the interval you trade. Here are some basic ideas and tools to help you get a sense of a solid short.

Trend exhaustion: When you have a prolonged bullish trend there comes a point when the trend hits a brick wall. The buyers just stop coming and the pair hits resistance. Soon after, those that already hold positions fear the trend is reversing. They quickly liquidate their position which results in a forceful short from the top.

There are countless methods to identify trend exhaustion but here is a rather simple one.

As you can see in the chart below, in this case a stock called Palo Alto, hit the top point of 200.  But only when it fell back to 190 it stated to move rather quickly and abruptly down. What happened next was that the trend line was briefly broken. But there is another even more important element here and that is the MACD below. The histogram bars that preceded the correction when the trend was rising were rather moderate. In comparison, look at those created in the other direction when there was a short.

Short Selling

Source: esignal

That clearly indicates that there is fear around 190 which triggered quick selling. A trend has to have at least two attempts before heading lower. Thus, it’s clear that another attempt will have to be made to break the 190.

Since we already know there is fear around this point we can expect a short. Once we reach the neck, the point where the selling started last time, that’s our entry point for a short. That, of course, will need to be closed quickly afterwards.

Overbought: Another basic strategy to capitalize on fear with a short is when a pair is overbought. Once again, there are numerous paths and methods to trade on this but here is a simple one. Looking at the EUR/USD as our example we will need to look for two things. When the pair closes above the price channel on the one hand and the RSI is at an overbought level on the other, the pair is overbought. That means an abrupt short is about to begin.

Short Selling

Source: esignal

Filed Under: How does the forex market work? Tagged With: overbought, oversold, S&P 500, short strategies, trend

Four Reasons Why Short Strategies Are More Difficult Than You Think

January 31, 2014 by Andrew Selby Leave a Comment

Short strategies are endlessly appealing to quantitative traders. The ability to take profits out of the market at times when everyone else is panicking and losing money is the type of thing that almost every trader dreams about.

While many traders acknowledge that there is money to be made on the short side of just about any market, we all know that it isn’t an easy task. Short selling is generally considered to be much more difficult than trading long positions, and there is good reason for that.

short selling

Short strategies have tremendous appeal to quantitative traders, but there are more complicated risks than backtesting results are able to document.

Cesar Alvarez has been trading short strategies for years. His logic explains the appeal:

I love shorting stocks because it is very hard psychologically, because of that, I believe that there is a good edge there.

In a post on his blog last week, Cesar admitted that he is considering discontinuing his short strategy that had been profitable from 2006 through 2012. He explained that four different issues came up over the course of 2013 that his strategy really struggled with. These issues don’t appear to be major hurdles in backtesting results, but they are much more complicated in live trading situations.

Can You Take All of the Signals?

The first concern that Cesar discusses is when brokers are unable to locate shares for you to borrow, which is essential in a short sale. Cesar says that, at times, he has experienced difficulties borrowing shares of extremely liquid stocks for short sales.

As you know, failing to take one or more of the trades signaled by a strategy could be the difference between a profitable year and a losing year. There is no way to predict or backtest for this type of issue.

Interest on Borrowed Shares

Another drag on the performance numbers of Cesar’s short strategy has been the interest charged for borrowing shares to sell short. He explains that there is very little consistency in this area. For that reason, it is difficult to adjust your backtesting to account for this variable interest.

Increasing Losses

The third issue that Cesar mentions is that a a position moves further against you, it will become a larger portion of your account. This is exactly the opposite of what happens with losers in long positions.

As the price goes further and further against a short position, more and more capital is required to buy back the stock that was borrowed and sold. Cesar discloses that this took a huge toll on his short strategy in 2013.

Black Swan Gaps

The final complication that Cesar has encountered with his short selling strategy is the large gaps that can occur for any number of reason. These Black Swan movements are completely unpredictable, so there is no way to account for them during backtesting. However, when they do show up, they have the power to wipe out an entire account quickly.

 

 

Filed Under: Test your concepts historically, Trading strategy ideas Tagged With: backtesting bias, short strategies

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