- 2002: Volume 11, No. 2 Top Trader Q&A

Many trading experts feel current market conditions are ideal for short selling. Best-selling author and trading coach, Toni Turner, agrees. But shorting stocks without proper guidance, training and a full understanding of the technique can be risky business.

Question: Toni, why is it important to know how to sell short?
Turner: In today's volatile markets, knowing how to sell short can yield tidy profits. In fact, many professional traders insist more money can be made on the short side of the market than on the long side. Why? Because fear tends to be more powerful than greed, stocks usually tumble faster than they rise. Therefore, as a short-term trader, if you know how to sell short safely and effectively, you can take rapid gains out of the market.

Question: Selling short makes me feel uncomfortable. Why is this?
Turner: At first, selling short feels "backwards." After all, we are conditioned to buying first, selling second. When you sell a stock short, you're selling a stock you don't own... while it's moving up (uptick rule)... in the hopes that it will tank... so you can buy it back. Huh? Popular rhetoric also warns: when you buy a stock, you can lose only your initial investment—it can't fall past zero. If you sell short, though, and the stock moves up a zillion points, you can lose your initial investment, plus more. While that's true, as a savvy trader, you would take careful measures to prevent that scenario from developing.

Many professionals insist they profit more by selling short than they do on the long side. Once you learn how to sell short properly, your nervousness will disappear—and your profits can certainly increase.

Question: What are your favorite shorting setups?
Turner: I favor two setups. First, I scan for a stock that's completed an uptrend on a daily chart and is "rolling over" into a downtrend, optimally being dragged south by its related sector and overall market conditions. When the stock breaks price support, possibly the neckline of a head-and-shoulders pattern, or a double top, I sell short as it breaks downward.

The second setup presents higher risk, and must be closely monitored. I locate a stock that has shot straight up on a daily chart and is extremely overextended. (Assumption: things that fly straight up, fall straight down.) When the stock gets oxygen-deprived and starts to weaken, I pounce. Then I set a buy-to-cover stop loss point, lowering it as the stock falls. When the stock nears previous support, I take profits swiftly.

Question: Could you please explain "short squeeze"?
Turner: Getting caught in a short squeeze can be a memorable event! Say you're short 500 shares of Stealthy Software, and it's dropping like a rock. As it nears prior support, it slows and hovers for a few minutes. Suddenly, Stealthy makes a U-turn and shoots up like a missile. It soars past your entry point, screams above your stop-loss point, then heads for the moon. Frantically, you sell your shares at the market, then stare dumbfounded at your screen. What happened? When Stealthy touched prior support, buyers stepped in. At the same time, short sellers covered their positions. You have buyers buying—and short sellers buying—with little selling. In those conditions, stocks can rocket up fast and thus "squeeze" panicky short sellers out of their positions. Remedy: target possible support levels before you sell short.

Selling Short Safety Tips:

• Paper trade at first. Short liquid (high-volume), slow-moving stocks.
• Plan your trade and trade your plan.
• Figure stop-loss points before you enter a trade and always adhere to them.

JON "DR. J" NAJARIAN

People who trade regularly have long realized the benefits of trading options instead of stocks. Best-selling author and chief market strategist for BeyondTheBull.com, Jon "Dr. J" Najarian explains the benefits of trying options as an investment alternative. Learning to profit strategically and consistently takes knowledge and guidance as the following interview makes clear.

Question: Option trading has been increasing at an amazing rate. Why?
Najarian: It's simple. Active traders have found options are superior to stocks in many ways. The leverage and protection they provide can substantially boost returns. And, with big discounts in option commissions now being offered, it's easy to see why option trading has gone up dramatically.

Question: What common mistakes do option traders make that hurt their performance?
Najarian: Investors often buy an option they think is cheap, playing for a "home run" when it's the "single hitters" that make solid, long-term gains. When you bet on cheap options, you're really expecting an extraordinary move. Very few traders accurately predict such moves and thus, set themselves up to fail.

Also, option traders frequently fail to give themselves enough time to be right. If you buy a stock, you own it for life. But options expire. So, buyers of options need to understand the life cycle of an option. Time decay is a critical factor that can kill your investment if you don't pay attention to the details.

Many traders want big gains, fast. But professionals move the odds in their favor through the use of spreads, in which you buy one option for each option you sell. Buying a call option and selling a like number of another call option at a higher strike price establishes a bullish trade that addresses the negatives of time decay. The trade off is limited upside—as you've capped profit potential by selling the higher strike call. And, while investing $2,000 to make $2,000 might sound boring, most prudent investors will take boring over losing!

And, too frequently, I see option investors lose money simply because they failed to get a basic education about the product-or training through easily available books and courses.

Question: What benefits do options offer investors that stop orders do not?
Najarian: Traders often place stop orders to cut losses if their stock falls beneath a certain price point. But, stop orders provide little real protection, as downward gaps in price, due to downgrades, earnings shortfalls, or litigation slam stocks down by 20 to 50 percent. You needn't look further than Enron (ENE), or Halliburton (HAL) to see how this exact price action would have blown through even the most conservative stop order.

Contrast that disaster with a trader that purchased a put option instead of setting a meaningless stop order. The put provides absolute downside protection from its strike price down to zero, regardless of gap moves that destroyed traders who depended on stop orders. Another benefit is that the put protection remains in place until expiration without ever being triggered, regardless of how many times the strike price is pierced. The stop order would be triggered by a single move to that specific level, taking you out of the market and eliminating any further appreciation.

Question: Should investors consider investing in LEAPs as a surrogate for stock investing?
Najarian: Absolutely! LEAPs, or long-term options, have been a godsend to the active trader. You can usually own them for less than 10 percent of the cost of stock ownership and they help control the upside or downside of that stock through the use of LEAP calls or puts. Since LEAPs have expirations up to three years into the future, their time decay is virtually nil versus short-term options. When investors use LEAPs as a stock replacement and sell the short-term more rapidly decaying options against them, they are making great use of both leverage and time decay, thus vastly increasing their odds of making money.

Question: Will single stock futures impact options trading?
Najarian: I think options will provide a tremendous "protection" benefit for anyone who trades single stock futures. Here's why: presently, the best leverage a margin investor can employ is 50 percent. However, single stock futures can more than double that leverage, as they may require just 20 percent good faith margin. That's great. But—while S&P futures rarely move even 10 percent in a day, many stocks move far more than 10 percent in any session. This volatility could set off frequent calls from your broker to cover the extra margin.

Here's where options can provide real protection: a prudent bullish trader will address the margin risk by purchasing a put option. The bearish trader could cover upside risk of the short future with a call option—thereby truly hedging the trade. But be warned—this is tricky new territory. Be sure you're on solid ground before plunging into this arena by getting guidance from a book, workshop, video course or recognized authority.