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Short selling with Candlestick basics

 

 

 

What is short selling a stock? Why are people afraid of it?


Short selling is a method which allows you to profit from a stock anticipated to move lower. Instead of the regular way, where you first buy a stock at a lower price and then sell it at a higher price (hopefully), this method works in reverse. If you anticipate a stock will move lower, you can sell the stock first and then buy it (cover your short) back at a lower price after the expected decline takes place.

The general mechanism of how it works is as follows: You tell your broker that you want to short sell a particular stock. As with the regular method, you will have to specify whether it’s a limit or market order. Since you don’t own that stock to sell, the broker will borrow the stock from somebody and sell it in your name. When the stock moves lower as expected, you can tell the broker to cover your short, i.e, buy those shares back. The broker then buys the shares back and you are no longer in debt of the borrowed shares. You meanwhile, made a profit without ever owning any shares.
There are some limitations regarding when you can use this method. The following are the most common ones:
-You have to have a margin account to do short selling. Brokerages will not allow shorting in regular cash accounts, eg shorting is not permitted in IRA's.
-The stock has to be priced above $5 to be eligible for shorting.
-You can only short a stock on an uptick. 

Now we come to why this process is considered dangerous by some people. Consider what happens when you place the order to short sell. The broker has borrowed the shares for you. If the stock starts rising, rather than moving lower, there could potentially come a point where the stock is worth much more than your allowable margin amount. Then if you want to buy it back, how are you going to afford it? So what do the brokerages do? They issue something called a ‘margin call’ to you. This is a notice from the brokerage telling you to deposit additional funds in your margin account. If not, the brokerage has the full right to liquidate your account and pay for the rising stock you have shorted. That ‘margin call’ is a dreaded thing among traders. 

One has to agree that for the average traders it is a dangerous thing to short stocks, because of the possibility of a rising stock and the inability to follow any disciplined stop loss procedure. But for a candlestick trader, shorting a stock is no more dangerous than buying a stock. This is because, stop loss procedures are very simple and easy to execute based on what the signals tell you. 
If one has shorted a stock, because there was a candlestick sell signal in an overbought condition, what is the logical way of getting stopped out? If the signal which prompted the short gets negated, then is there a reason to be still short the stock? No. Simple analysis of the candles will tell the candlestick trader, that the short is not going to work as planned. That is the point the trader buys back the position with a breakeven or a small loss. This is no different from what the trader would be doing when a buy scenario exists. 

Using the in-built common sense approach in candlestick theory, traders can profit from both sides of the market movement confidently. 
The following chart shows an optimum entry point for shorting DELL after a Bearish Harami is formed in overbought conditions. A trader would enter a short order on confirmation of the Harami.. When the stock exhibits a confirmed Inverted Hammer, the trader puts in his order to buy back the shorted shares.

Chart courtesy stockcharts.com