I just finished reading another William O'Neil book, How To Make Money Selling Stocks Short (purchase), and in the book he listed six great rules for selling stocks short.
This list below can be found in the book on pages 32 and 33, which I definitely recommend reading. The whole back half of the book is stock charts with straight forward technical analysis of big runners that become great stocks to short. Some of the charts were more easy to read than others but the main concepts were what mattered.
6 Rules for Short Selling, William O'Neil
- The general market should be in a bear trend, and preferably in a position that is relatively early in the bear trend. Shorting stocks in a bull market does not offer a high probability of success, and shorting stocks very late in a bear period can be dangerous if the market suddenly turns to the upside and begins a new bull phase.
- Stocks that the would-be short seller has identified as candidates for short sales should be relatively liquid. They should have sufficient daily trading volume so as not to be subject to rapid upward price movement if the stock experiences a sudden rush of buyers that can result in a significant short squeeze. A general rule of one million shares or more traded per day on average is a reasonable liquidity requirement.
- Look to short former leaders from the prior bull cycle. Stocks that offer the best short sale opportunities in a bear market rend to be the very same stocks that led the prior bull phase and had huge price run-ups during the bull market.
- Watch for head & shoulders top formations (explained and shown in the book) and late-stage, wide, loose, improper bases that then fail. These are your optimal short sale chart patterns.
- Look to short former leaders five to seven months or more after the stock's absolute price peak. Often, the optimal shorting point will occur after the 50-day moving average has crossed below the 200-day moving average, a so-called "black cross," and this may take several months to develop. Once a former leading stock has topped, monitor it closely and be prepared to take action when it signals an optimal shorting point.
- Set 20-30% profit objectives, and take profits often!
This list could make you millions if you follow its core guidelines. Three out of four stocks follow the overall market trends, so it is no wonder that shorting only in a bear market is the best way to go (unless you day trade stocks of course). Another point mentioned in the book not listed above was a comment Mr. O'Neil made regarding how you should set cover stops at half your normal rate. So, say you usually set stops at 8% below your purchase point, Mr. O'Neil recommends you set your cover stop 4% above your short price. The reason being is because shorting is a more delicate and disciplined game where do you do not want to get burned.