Timing is crucial when it comes to short selling. Stocks typically decline much faster than they advance, and a sizeable gain in a stock may be wiped out in a matter of days or weeks on an earnings miss or other bearish development. The short seller thus has to time the short trade to near perfection. Entering the trade too late may result in a huge opportunity cost in terms of lost profits, since a major part of the stock’s decline may already have occurred. On the other hand, entering the trade too early may make it difficult to hold on to the short position in light of the costs involved and potential losses, which would skyrocket if the stock increases rapidly.
That said, there are times when the odds of successful shorting improve, such as the following –
- During a bear market: The dominant trend for a stock market or sector is downward during a bear market. So traders who believe that “the trend is your friend” have a better chance of making profitable short sale trades during an entrenched bear market, than they would during a strong bull phase. Short sellers revel in environments where the market decline is swift, broad and deep – like the global bear market of 2008-09 – because they stand to make windfall profits during such times.
- When stock or market fundamentals are deteriorating: A stock’s fundamentals can deteriorate for any number of reasons – slowing revenue or profit growth, increasing challenges to the business, rising input costs that are putting pressure on margins, and so on. For the broad market, worsening fundamentals could mean a series of weaker data that indicate a possible economic slowdown, adverse geopolitical developments like the threat of war, or bearish technical signals like reaching new highs on decreasing volume, deteriorating market breadth, etc. Experienced short sellers may prefer to wait until the bearish trend is confirmed before putting on short trades, rather than doing so in anticipation of a downward move. This is because of the risk that a stock or market may trend higher for weeks or months in the face of deteriorating fundamentals, as is typically the case in the final stages of a bull market.
- Technical indicators confirm the bearish trend: Short sales may also have a higher probability of success when the bearish trend is confirmed by multiple technical indicators. These could include a breakdown below a key long-term support level, a bearish moving average crossover like the “death cross” (which occurs when the 50-day MA falls below the 200-day MA), bearish divergences etc.
- Valuations reach elevated levels amid rampant optimism: Occasionally, valuations for certain sectors or for the market as a whole may reach highly elevated levels amid rampant optimism for the long-term prospects of such sectors or the broad economy. Market professionals call this phase of the investment cycle “priced for perfection,” since investors will invariably be disappointed at some point when their lofty expectations are not met. Rather than rushing in on the short side, experienced short sellers may wait until the market or sector rolls over and commences its downward phase, since Keynes’ aphorism – “The market can stay irrational longer than you can stay solvent” – is particularly apt for short selling.
The optimal time for short selling is when there is a confluence of the above factors. This is most likely to occur during the early stages of a bear market, which typically happens after new highs have been scaled.