3 Common Short-Selling Mistakes

07/18/2011 3:30 pm EST

Focus: STRATEGIES

Alexander Elder

Author, The New Trading for a Living

Being able to short the market is valuable dimension in any trader's arsenal, and Dr. Alexander Elder discusses some of the most common mistakes that short sellers need to avoid.

Good traders are diversified in that they know how to sell short and go long, both so that in the right market, they can do the right type of trade. 

Our guest today is Dr. Alexander Elder and he is here to talk about the mistakes that people make when they are shorting stocks and other markets and what to do to avoid those. 

Dr. Elder, what do you suggest? First of all, what are some of the mistakes that traders make when they are first starting to short?

Well, the list of mistakes is so huge that I actually have a book that came out and is being sold at Amazon; it is called The New Sell and Sell Short. So the list of things to do right and the list of things to do wrong is actually quite fat.

All right, maybe you can give us the top three.

I’ll give you the top three. The biggest mistake with selling short is not selling short. 

So many people are just viscerally terrified of shorting. They say “Ah, if I sell short and the stock goes against me, there is no limit; I could be wiped out.”

And to that I have one answer: Use stops, and if you don’t use stops, you deserve all the troubles that are going to come your way. So that is mistake number one, not shorting. 

Mistake number two: What do I sell short? People will go and sell short something popular, something they heard about. That is not the way to do it. 

When you are learning to sell short, find a stock that you hate. Find a stock that is a dog that you know if you buy the dog, it is going to bite you on the anatomy. That is the stock you should sell short. 

So rule number two, find stocks that you hate. Don’t short strong stocks, short stocks that are turning around—not stocks that have crashed, but those that have done this “fishhook” business, gone up, rolled over, and now are headed down. 

And another thing, when you are learning to sell short, do it slowly. So many people try to get rich quick, and when you are learning a new skill, whatever it is, buying, selling short, driving a car, whatever the new skill is, you want to start in a low-key way on a little country road; don’t get on the expressway. 

So when you are learning to sell short, do a small size. This way your head will be clear and you’re not going to get all confused because the money is clogged and combined. 

Now I need a certain amount of margin to sell short as well, right?

In order to sell short, you have to have a margin account, but it doesn’t have to be anything major or special.  You have to get special approval for shorting, but it is not a big deal.

So when I’m starting small, should I start with 100 shares or ten shares; what do you suggest?

Well, it depends on what you are shorting. If you want to short Amazon.com (AMZN), ten shares is plenty. If you want to sell short something like Ford (F), selling for $15 or $13 (at time of interview), 100 shares is no problem, but to me a small lot is a great learning size. 

You really have to design a schedule. After I do X number of successful trades—three, five, seven, you decide—but after I do X number of successful trades, I’m going to double my size. 

If I do half of that number in bad trades, I’m going to start cutting my size back to what it was. So let’s say, for example, at five trades I jump up, so now you are shorting 100 shares. At 100 shares, you have done it five times and at the end of five shorts, you have more winning trades than losing trades. You are ahead of the game.

Now you can start shorting 200 shares, but if you lose three times, you have to go back to the previous step. So in other words, win five times to move up, lose three times and move back down.

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