Finding Short Candidates With Technical Analysis

When shorting equities, one often faces the challenge of distinguishing between a topping formation and a change in trend. Many successful short sellers will try to focus their efforts by looking at clues that are offered from the schools of technical analysis and fundamental analysis. Read on to find out how studying these different methods a trader can gain confidence in shorting the market.

Technical Analysis

Since the equities markets are primarily dominated by long traders, short traders try to prey on the weak longs to trigger breaks and start downtrends. They try to put enough pressure on the market to create situations where the weaker long get out because of the fear of giving back gains. It is the job of the short seller to find tools, such as different chart patterns or indicators that are used specifically for predicting the start of a decline or a panic sell.

Trying to short a market using technical analysis usually means finding an overbought indicator and a trend indicator that is reliable enough to show the equity is a candidate for a down move. The overbought indicator is most likely either a relative strength index (RSI) or a stochastic oscillator. A trend indicator can be as simple as a short-term moving average (MA).

When using an oscillator, the trader is relying on it to show that the market has reached a level that indicates it may be running out of buyers. A trend indicator, on the other hand, is usually used to show that support has been broken because the market has become weak. When shorting an equity, it is very important that the trader knows that with an oscillator they are selling strength, but with a trend indicator, they are looking to short weakness.

Fundamental Analysis

Fundamentally, there are several ways to pinpoint short candidates, including bad earnings, lawsuits, changes in legislation, and news. The key to using the fundamentals or news to trade equity on the short side is making an informed decision about whether the event taking place is a short-term issue or a long-term event.

A negative news event is most likely to cause a spike down in a market and not necessarily set up good long-term decline. In this case, the spike has most likely been caused by stop-loss orders being triggered. A long-term decline can start with a spike down but is most likely triggered by a series of negative events that give traders confidence that a longer-term downtrend is developing.

An example of a spike down triggered by a news event is when a company’s earnings are reported lower than the consensus. Traders react by selling the stock. A series of negative earnings reports, however, is the type of fundamental that often attracts the short seller.

When an event is significant enough to crack the support of a market, volatility will often increase as nervous long traders begin to feel the pressure of the short sellers trying to drive the market lower. This is when a trader can use both types of analysis to determine the severity of the decline that is in store.

In general, a negative news announcement is often accompanied by heavy volume and wide ranges as short-selling pressure builds in an attempt to drive the stock to technical levels which will trigger more sell stops. The short seller, driven by the confidence of the negative fundamentals, continues to try to push the market through support points, which makes it painful to hold on to long positions.

Short Selling in Action

Heavy volume, wide ranges, and lower closes often catch the eye of short traders. Upon further investigation, the short trader will then decide that the news event or fundamental change is strong enough to trigger a liquidation of long positions. These conditions may encourage short sellers to initiate new short positions.

An interesting example occurred with the auto marketplace Carvana (CVNA) at the start of 2021. The company, which buys and sells used cars, had experienced a ten-fold increase in its stock price from its 2017 IPO, thanks to increased demand during the COVID-19 pandemic. Figure 1 illustrates how volume trended lower, even as prices increased.

Figure 1 (Source: TradingView)

During this time, short sellers could have monitored momentum indicators like the relative strength index and the stochastic indicator. These are oscillators that measure the speed and strength of recent price changes. After a prolonged move up and a series of higher tops and higher bottoms, the RSI and stochastic indicators reached overbought levels. This was enough information to cause traders to think a top had been formed.

CVNA offered the first clue of a top on July 1, 2021, and began its break downwards in October. This move was the largest down move in terms of price and time that the stock had seen since its IPO in 2017. Compared to previous breaks, this move was much more severe, which was a major clue that CVNA was topping seen in Figure 2.

Figure 2: CVNA price (top), Relative Strength Index (Middle) and Stochastic Index (bottom). Source: TradingView

While technical factors helped identify a possible top, short traders would also have looked towards fundamental indications of Carvana’s reduced fortunes. In Nov. 2021, Carvana revealed that it had fallen short of its quarterly earnings target by $220 million, while its net loss had more than tripled from the same period a year earlier. Rising interest rates and a cooling car market gave additional confidence to short-side traders.

CVNA continued to trend downwards through early 2022, as short sellers likely gained confidence from the unfavorable fundamentals, news stories, and the visibly bearish chart patterns. Eventually, as prices fell, volumes increased, indicating that bullish traders considered the stock a bargain at its new, lower prices. At the same time, momentum indicators like the RSI and SMI showed that CVNA was in deeply oversold territory, suggesting a likely reversal. CVNA began to climb in early 2023, eventually returning to overbought territory.

Figure 3 (Source: TradingView)

The Bottom Line

In summary, to be a successful short seller, one must be aware of the clues on both the price charts and on the balance sheets. Technically, the short trader must be able to distinguish between a topping formation and a change in trend. They must learn the types of formations that indicate a short-term top or a long-term trend.

Fundamentally, the short-trader has to distinguish between a one-time news event and the start of a series of negative events. By learning how the technicals and fundamentals work together, a trader can gain confidence that can help them comfortably to go short in the market.