How to make money selling stocks short by William J.O'Neil

William O'Neal, the founder of Investors Business Daily and author of the influential book How to Make Money Selling Stocks Short, provides a detailed exploration of the mechanics of short selling and offers numerous examples of how to profit significantly from this strategy.

Understanding the Basics

O'Neal's foundational premise is that stocks generally tend to rise over the long term, leading to many success stories of substantial profits. However, he emphasizes the cyclical nature of the market, where what goes up must eventually come down. O'Neal delves into the anatomy of a short sale, illustrating how investors can capitalize on the downturns.

William O'Neal's Journey

In 1963, O'Neal bought a seat on the New York Stock Exchange, and a year later, he established William O'Neal & Company. Twenty years later, he founded the highly regarded Investors Business Daily. Throughout his career, O'Neal interacted with hundreds of investors, portfolio managers, and institutional clients, discovering a widespread lack of knowledge about short selling. He noted a psychological barrier preventing many from considering anything other than buying and holding stocks. O'Neal famously remarked that buying without the ability to sell is like a football team with all offense and no defense; to win, one must master both.

The Mechanics of Short Selling

A short sale involves borrowing a stock from a broker and selling it immediately at the current market price, with the hope of buying it back at a lower price in the future. This strategy is the inverse of the traditional "buy low, sell high" approach.

Real-Life Example

Consider a scenario involving David and Derrick. David owns a mobile phone valued at $1,000. Derrick borrows the phone from David and sells it for $1,000. A week later, Derrick buys the same model phone for $800 and returns it to David, pocketing a $200 profit. However, if the phone’s price had increased, Derrick would have incurred a loss. The challenge in short selling is to sell the asset at a high price, anticipating a lower price in the near future.

Analyzing a Stock Chart

In the context of stock trading, let's look at an advanced trader identifying a head-and-shoulders pattern on a stock chart. The trader notices two inflection points creating a support line, with the price significantly above its moving average. When the price breaks through this support line, the trader borrows shares and sells the stock short. As anticipated, the price declines, and the trader buys back the stock at a lower price, around the moving average area. For instance, if the stock was sold short at $10 per share and bought back at $5, the trader's profit would be $5 per share.

Technical Aspects and Strategy

O'Neal emphasizes the importance of timing short sales with the general market trends. He advises waiting for the market averages to show signs of weakness before selecting and timing individual stocks to short. An example is the Dow Jones Index in 1984, where several distribution days indicated a market downturn. Five distribution days within a two to four-week period suggest it’s time to raise cash.

Further, O'Neal outlines key technical indicators for short selling, such as a stock price breaking through its 200-day moving average and a rising level of support. He identifies heavy volume on distribution days breaking prior levels of support as signals to consider shorting a stock.

Case Studies

1. Cisco Systems: A former bull market leader peaking in March 2000, Cisco's death cross (50-day moving average crossing below the 200-day moving average) was a key short-selling signal. High volume distribution days and periods of low demand indicated ideal points for short selling, leading to substantial profits as the stock price plummeted.

2. Corning: Another example from the late 1990s, Corning’s death cross and a failed rally above the 50-day moving average on high volume signaled an opportune moment to short sell. The stock price fell dramatically, yielding significant profits.

3. Krispy Kreme Doughnuts: The moving average crossover, a four-week rising wedge on decreasing volume, and a significant drop through the 50-day moving average on high volume marked the perfect short selling opportunity. The stock price dropped from $34 to $12 per share, demonstrating the effectiveness of the strategy.

Critical Advice

O'Neal warns that if a stock has been in a downtrend for more than 18 months, it is likely too late to short sell, as the risks increase significantly. He advises ensuring the overall market is in a downtrend before attempting short sales and selecting stocks with good liquidity (ideally 1 million shares traded daily). Former bull market leaders often make good short sale candidates due to their swift price declines.

Conclusion

William O'Neal's How to Make Money Selling Stocks Short provides an in-depth look at the nuances of short selling, backed by numerous annotated charts and real-life examples. The book is highly recommended for advanced traders due to the inherent risks involved in short selling.

Rating: Four Stars

For those looking to incorporate short selling into their trading strategy, this book is an invaluable resource, offering comprehensive insights and practical guidance.

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