Basic Instructions for Shorting



Basic Instructions for Shorting

Using ElliottWave’s Short Term Update[1]

Preface

The information contained in this document is subject to error. It is supplied in good faith and is not intended as a recommendation to buy or sell stocks. Use it at your own risk. It is not for the faint-hearted and takes a fair degree of good sense to apply its premise. It is incomplete and constantly revised.

If your principle goal is not to lose money then this information is not for you. You must risk loss at every juncture of these instructions. I have recently sat on paper losses in excess of a quarter of my entire portfolio. The first fiscal year of trading I lost all my gains and then some. Theoretically, the whole of your investment is subject to loss. Often I have read that an investor should be prepared to lose the entire sum. This is sound advice from a rational standpoint and it must be said. But, what is not so obvious is that investment philosophy most often has a paradoxical relationship to profits. So, while you are going to read the word “loss” again and again in this document the reasons for doing so are many and not intended as an obstacle to the process.

Further, in the line of philosophy, investing is not gambling. It is gambling if you treat those investments like a casino. In a sense you have to be both a technician and an artist to do well. A technician follows functional rules. An artist focuses on form rather than time and price. You must do both with wave analysis.

Elliott is only one of many approaches that have a proven track record of gains. This information can be used as a part of Elliott principles or in conjunction with other systems.

In February of 2002 Japan passed stricter laws on short trading (ref. August 19, 2002). This preceded a bottoming in the Nikkei. It is also possible that this occur again in the United States (e.g. Jan. 1980 Comex futures). However, such action is usually associated with market bottoms. In such a case it is probably time to be going long[2] on stocks anyway.

Finally, there is a sense in which this document makes the shorting process more complicated than it is in daily practice. It was only after I began shorting that I learned the details which this documents attempts to explain.

Definition

To short a stock simply means you are borrowing the stock from a broker at a certain price in anticipation of its price falling in the future. ElliottWave International foresees the opportunity for this strategy to be the overriding movement of the indexes during the remainder of 2002 and into 2003.[3]

The principle in shorting is that you are essentially borrowing the stocks from another owner, much like when you make a loan from a bank. The broker either has the stock in inventory or he borrowed it from a client at another brokerage firm.

In return for the broker letting you borrow these shares you are charged a nominal interest fee.[4] The difference in the price from the time you borrow the shares and the time you return the shares to the borrower is your profit – or loss.

This document does not cover futures or options.[5] One of the principle reasons for this is that shorting a stock allows for errors in timing. Futures and options are more precise instruments with greater profit potential but require a greater level of expertise to manage potential losses.

Allowing you to use someone else’s shares implies a couple things:

1. The stock must be available to borrow and you may be required to return the shares at a loss. You may not be able to retain them indefinitely especially if the demand for the purchase of the stock is high. For the most part, however, brokerages do not place a time limit on the stocks they loan because a.) They make a commission either way, and b.) They want to keep their customers happy.

2. The short interest rate depends on the stock and whether the stock is trading on margin at a profit or loss. Wall Street Journal or Investor’s Business Daily have lists of rates corresponding to the stock symbol. STU is, as the name implies, short term. However, you may need to hold a position through a correction[6] that can last weeks or even months.

3. You must have a margin account[7] to be able to short stocks. The stock itself must be marginable and shortable. It is best to short on equity, not margin – especially during corrections. If the price continues to rise and you are trading on margin you may get a margin call and be required to do one or more of the following: a.) Deposit more cash in your brokerage account or b.) Return some of the shares to cover the brokerage’s margin requirements.

4. I found out this one the hard way. If you hold a short position then you have to pay out cash to cover dividend obligations. This obligation arises because the original owner of the stock (i.e. the individual or institution from which you have borrowed the stock) would receive a dividend payment if they had not lent you the stock. Because you have sold their stock to another party, this other party receives the dividend that accrues on the ex-dividend date. As a result, you have to “make-up” dividend payments to the original stockholder during which your short sale is outstanding.

The Process

To borrow a stock in this way you place a “sell” order first for the number of shares you want to borrow. Most online brokerages give a summary of the transaction before it is placed and thereby let you know that you are intending to short the stock. Although the logic of beginning the transaction with a “sell” seems convoluted remember, you are attempting to purchase at a higher price – usually the point where an owner would want to sell it. Also, you are truly selling it. You are borrowing it from your broker and then selling it to another buyer. Your broker arranges this and it is transparent to you.

Then, assuming the price falls to a level STU anticipates, you return the stock to the broker with a “buy” order – the usual low-price point at which a long trader buys shares. Again, the difference between the price of the stock when you borrowed high and returned the shares at a low is your profit.

Strategy

Study Elliott Wave theory. Purchase Elliott Wave Principle by Prechter and Frost. It is essential to understand its fundamental structure. To intelligently participate in nearly any study of trading you should know wave theory because waves are commonly discussed. It is not necessary to know precisely where you are in the developing waveform so long as you understand its position relative to its larger context. The better your understanding the better your profits and composure in the inevitable maelstroms that can occur.

Take strategic losses. There is a difference in being wrong and staying wrong. For example, you could, theoretically, hang on to your stock during an upward correction in an overall deflationary[8] period. While you’d like to think that you rarely, if ever, sold at a loss this is usually counterproductive for the following reasons:

1. If the stock rises above Elliott’s initial resistance levels and appears to be tracing out a higher Fibonacci resistance then it stands to reason that your profit will be greater if you sell at the loss and regain it by shorting the stock again once the higher resistance levels draw closer. Yes, you will be purchasing fewer shares at a higher price but the gains usually outweigh the reduction in shares being leveraged.

2. You are sidelined, possibly for a long period of time: corrections sometimes take weeks, even months. You could have recovered the loss by shorting the unexpected spike in prices. Also, being sidelined reduces your learning experience. We learn principally by doing. When you just watch the market the experience is less educative.

3. The psychological effect of watching an upward correction press a 10 to 20% loss can be debilitating. Corrections since the index top in 2000 have registered in the 20% range before declining in earnest again.

4. I have read that most professionals have three losses for every gain. They have, however, learned how to minimize the loss,[9] free up that “dead” money, and employ it elsewhere for immediate gain. Obviously, if you are not a nimble this is not a good strategy.

5. There is a slight potential, even when not using margin, that your broker could ask for the shares you borrowed back.

This does not mean that you accept a loss under every circumstance. It is a general principle. If you prematurely short “up to your eyeballs” then this loss may be too debilitative and counterproductive. The trend will eventually erase the loss. In such a case wait it out.

Stay with index stocks reflected in the Short Term Update. Until you gain experience in wave theory it is wise to stick with the indexes covered in STU. Below is a list of corresponding stocks that are typically used as proxy trading instruments for these indexes.

|Index |Proxy Stock Symbol(s) |Notes |

|Dow Jones Industrial Average |DIA |Use DJI to track the index. |

|NASDAQ |QQQ (VRSN, VRTS) |Use NSDQ to track the index. VR stocks only|

| | |influenced by NSDQ. |

|S&P 100 | |Largest and most liquid of S&P 500 |

| | |companies |

|S&P 500 (500 companies, e.g. Wal-Mart, |SPY (tracks S&P 500), XLK (tracks |XLK is tech weighted. It will diverge |

|Microsoft) $SPX to chart it. |technology sector of S&P 500) |slightly in wave patterns but has a lower |

| | |price. |

|S&P 600 |IJR |Small cap stocks. |

|Silver (XAU) |PAAS |Silver. Historically greater % gains than |

| | |gold in depressions. |

|Gold (XAU) |ABX |Gold. A mining company. |

|Biotech Exchange |IBB | |

|Energy |IXC |E.g. crude oil, but not as good as futures.|

|Japan Index |EWJ |If the Nikkei rallies… |

Align yourself with the main trend. Currently this is hard down. Surprises in a bear market are to the downside. So be very careful when trading long on an index correction.

Use stops to cover gains, not losses. Some online brokers allow you to use trailing stops to keep you close to current point or percentage levels. I do not use stops to cover losses. Why? Well, for one, after hours trading can be vicious often targeting stops for profit. If you can keep an eye on your trades during the day then do so without stops. When you set a stop it will, on occasion, be targeted. Another reason I do not use stops to cover losses is covered in the “When All Else Fails” section below.

Short at the top of channels – Go long at the bottom. Channels (EWP[10] p. 69) serve as guideposts for the expected limits of a stock price movement in time. Trade with the slope only. Simple trades are always better. Generally, keep your long positions in the current market short in duration. Note, however, that channels typically break down after a few weeks or even days. Though once identified early they are good indicators of near-term direction.

Avoid market orders. When I have elected to purchase at market I usually get take a small loss on my entry or exit gains. Use limit orders whenever possible.

Stay glued to STU – even when it hurts. More often than not this results in greater gains. I’ve only lost when I abandoned it altogether and did what I was advised not to do.

Trade on equity, not margin. By “equity” I mean the cash value of your account. Cash is a far safer vehicle and has the added benefit of allowing you to sleep at night. The first time I traded on margin was an error, an error that fortunately turned to my benefit and, hence, allowed me to see the virtue of the practice. However, my policy to practice this is currently restricted to 3rd wave declines in a bear market and 3rd wave advances in a bull.

Use your head. If you are tired, have just been through a debilitating emotional experience, are sitting on an untenable position, are in a hurry, etc. that is just not the time to make a decision. For example, I’ve seen even the most stalwart and experienced traders wilt during a correction. In this example you must, by virtue of the process, operate on faith. Faith is not a hope that things will go your way. Faith is a conviction that belies appearances and is welded to facts. Appearances are often paradoxical to reality. Faith discerns between these opposing components: the seen and the unseen.

Do the math. Most uncertainties are avoided by keeping charts on both arithmetic and semi logarithmic scale.[11] More importantly, spend a good deal of time with Fibonacci resistance levels. They are probably the most single important tools for short-term analysis.

Patience. W.D. Gann has done very well and advises to sit it out. The trend is your friend. Once identified you buy into it during its entire tenure.

Wave 2 blues. This goes with the previous advice to sit things out. Wave 2 movements are sometimes called “terrible twos” because they whipsaw up and down. It is particularly important to exercise patience here. You may be sitting on a position for as long as a month or two during wave 2. That’s OK.

Seasonal bias. May begins what is known as a “seasonal bias” wherein the market enters its “weakest” six months of the year, with November-to-April being the “strongest” six months.[12] A dump in June usually follows a “Sell in May.” Further, there are positive seasonal tendencies in the market around the last few days of an old month and the first few days of the new. But this is not to say that seasonal biases are always consistent with wave patterns or larger cyclical forces. Seasonal biases can easily be swept aside by these and other factors. Nevertheless, it is important to recognize this predisposition of seasons and work with it. Note that when the end of a bullish seasonal bias produces lower highs than the bearish seasonals it portends a protracted decline.

Counter Arguments

I keep my investments close. It’s a private endeavor. In my reading, however, I’ve seen quite a few references to the problems attendant to this system. Also, it is unavoidable and usually necessary that a close friend or spouse understand the counter arguments involved.

Limitless losses. Recently a Reuter’s financial writer posed, “It’s a risky world. While those who buy stocks stand to lose only as much as they’ve invested in a worst case scenario, there’s no limit to the losses short sellers can incur because shares can keep rising.”

To this I answer, “True.” If you shorted a single share of a $10 stock then the stock soared to $100 a share you would lose your ten dollars and have to pay $90 to your broker’s account. But let’s go back to our casino analogy that began this article. This Reuters analyst’s premise is that of an investor who is treating the market as if it were an entertainment vehicle. This happy-go-lucky fellow puts his money into a stock slot machine and pulls the lever hoping his luck is right. Throughout this article I have provided technical procedures that eradicate this nonsensical assertion.

Turning the argument I’d ask the Reuters investment professionals to answer the following: Why did four stocks chosen by a random throw of darts nearly beat the average loss of 4 stocks chosen by investment professionals as reported in the Wall Street Journal?[13]

Further, the argument presupposes that valuations always rise; that periods of predictable and sustained devaluation rarely, if ever, occur. The blunder in this assumption is obvious.

It’s gambling. Following on the heels of the above objection is the protest that such investments are gambling. This would be true if you were betting on an uncertain outcome or playing a game of chance for stakes. But rational investments of any kind are academic exercises that, in most instances, virtually eliminate the venture as “betting” on an uncertain outcome. Even when losses do come they are nearly always recoverable by a reassessment of strategy. Also, the pleasure aspect is nominal when hour after hour you are pouring over charts and other technical instruments to govern your approach.[14] Further, bringing the argument to its logical conclusion, nearly all endeavors involve risk of some type. In every such decision we weigh the risk against the perceived benefit and make a reasoned decision. Marriage is a classic example. One might argue matrimony as the worst gamble of all. Yet few are so gallant as to call it gambling.

There is some support among professional investors for occasions when the market is in what is called “casino mode.” That is, a bad market that allocates money to the wrong projects. It is probably not a good use of terminology. It would be better to make the analogy of a sincere businessman who starts a company that is poorly timed and poorly executed. The effort is not a gamble strictly speaking, just a poor investment.

Still others argue that investing is an attempt to maximize dividend payments over a long period of time by assessment of value in a company’s stock. Trading is an attempt to gauge value in close technical measures without as much regard to the alleged value of the company. Neither are analogous to betting.

Markets are rigged. One popular view is that the “Fed” (aka “da Boyz”) gives money to the PPT (“Plunge Protection Team”) who buy up futures and select stocks at certain times during the day, in order to influence either short covering or longs to enter the market.[15]

It is believed that most of the time this PPT activity is designed to prevent a decline from turning into an outright panic. Some believe that the PPT is being heavily influenced right now by the President and his people to keep the party going. In other words, keep stocks from going down and a rally going at any costs.

Allegedly this strategy turns the Fed from a damage control agency, or “guiding force,” into a long-term investor, which is rightly believed to be outright, crooked manipulation. If we wanted the Government to fix the odds, they should account for that in their budget. But the Fed is accountable to no one, except their own private board, which is alleged mainly to consist of a scary group of huge overseas conglomerates.

But let's say, for the sake of argument, this is occurring. My question then is, “Does it really matter?”

If you look at a chart detailing the decline from April 1930 to July 1932 there were eight relatively lengthy periods where the DOW soared.

Overall, however, those years were marked by an incredible plunge into an abyss. For the wave theorist the mechanics of those eight periods are inconsequential to his overall approach. He still has the larger picture in mind and that is, at present, down -- hard down.

So while we may gripe about “da boyz” it seems this theory simply plays into the very fabric of the wave position and, in so doing, contributes to, and does not distraction from, the larger wave trend. They contribute in this sense: you cannot have progress in a wave trend (down right now) without the corrective process.

That’s how I look at it as I sit on paper losses during a correction. You simply cannot force your view on the market. In so doing you will eventually find yourself proving Fibonacci correct...and, for the Fed, not get re-elected.

Times are different. This can take on many forms. Recently, the concept of a “New Economy” flourished, i.e. the old rules of market timing no longer apply. But such an approach would have been perfectly acceptable in America in 1929. England and French markets thought so in 1720. Holland would have thought the same in 1637. The popularity of this concept has always preceded major market declines.

You profit from others’ greed and fear. Yes. The technical measurement of these competing emotions allows us to invest accordingly. However, lest we come away thinking this is somehow immoral, we might argue that marketing experts use the same information as do sales professionals and, for that matter, nearly anyone who offers a product or service. Even those occupied in legal and religious institutions utilize fear of punishment as an impetus to turn from wrongdoing and profit from it. Though profit may not be the direct motive from the religious endeavors it is a natural consequence.[16]

Perhaps more importantly intelligent investments actually curb the excesses of greed and fear in that they lend to the stability of the institution. Using the principles stipulated here has the effect of bringing an overpriced market down as well as bringing an oversold market up. This brings us to the next objection.

Short sellers drive the market down. First, declines are almost entirely due to selling from investors who have been driven to abandon their “buy and hold” approach, not from short sellers. Secondly, even if you removed short sellers from the market in a downturn, you cut off the very class of investor that must buy. Every short sale must be covered – it has to be purchased. There is no underlying buying power at all in a bear market banned to short sellers. Bans on free exchange injure the very people they are intended to help.

Elliott was wrong in the late 90s. ElliottWave has at its helm Robert Prechter. Prechter, for the most part, gives the organization its principle direction and hypothesis. By his own admission he misjudged the extremes that the stock mania carried in the latter part of the 90s. But he erred on the side of caution. I was one of those who followed him during that period and, frankly, became disillusioned when others gained profitably while Elliott stoutly defended an impending bear market.[17] Discounting his advice I reapportioned my assets into aggressive positions – and lost it all, and more, when, two years later the market plummeted according to Prechter’s assertions.

Further, the staff at Elliott Wave is very forthright when their analysis on a particular recommendation stalls. I have grown to appreciate their integrity and forthrightness. Fundamentally they are neither bull nor bear but follow wave patterns. Reading the first few pages of the Elliott Wave Principle volume provides an accurate approach to the proper usage of the wave method as well as its limitations. Understanding it for what it is, and is not, should greatly assist you in your employment of its rules.

Finally, the wave principle always holds true. The rules for wave formation give us the advantage of knowing what the market can and cannot do. The “three rules” in and of themselves assure a degree of success if employed consistently.

Asset Manipulation. Here the attack is more subtle. When you invest on a technical basis you are not producing anything. You are simply an “asset manipulator.” You are abandoning hard work.

Additional Resources

The following resources may prove helpful during the bear market.

| |Active board for the current trend. |

| |Securities trade analysis. Wave principle with an |

| |independent approach. |

| |Measures the money flow of institutions on a 2-week to |

| |2-month scale. Usually, readings above +100 are considered |

| |overbought and below -100 oversold. This guideline will |

| |become more extreme as the decline deepens. |

| |Has some good content. |

| |Put/Call ratios. Bearish readings are typically bullish and |

| |bullish readings are typically bearish. |

|OEX Volatility Index (VIX) for the S&P 100. Use “$VIX” (without the |Generally go long the US markets when the VIX approaches 50,|

|quotes) on most charting sites like |go short the US markets when the VIX approaches 20. But in |

| |the coming year or so we should see some extreme numbers |

| |here. |

| |An alternative opinion on the U.S. equity markets. |

| |Their Technical Analysis course is one of the best I’ve |

| |seen. |

When All Else Fails

You’ve done your homework. You’ve committed to your primary plan and – it fails. Staring at the following screen day after day can become debilitating.

[pic]

What do you do? Move to the secondary or alternate plan.

Speaking for myself, the “primary” approach was always a relatively simple election of several possible forms, ratios, and indicators. I choose the one that best fits all the data. I try to fix on the simplest wave form then the simplest wave ratio. Indicators like the VIX help but I don't put my focus there.

It shouldn't matter what tools you choose to put in your box here. If you don’t use waves that’s fine. What does matter is that you have a plan.

What if this election, my “primary” plan, gets blown out the door? Well, for me, this doesn't have to be depressing!

When I put together the first “election” I also have an alternative that fits the data I am putting my “primary investment” on but a) does not fit as many of the criteria as the first scenario and b) allows for “secondary investment” capital. That means you cannot put all your available cash into play unless your investment is well into the green and the tools are telling you the drop has further to go.

I do that because I know there are, at least, eleven different ways (according to my “tool box”) a correction can go.

So imagine that the alternative scenario appears to be playing out: a more complex correction. You are sitting on a 4-5K paper loss. I say, “So what?”

Naturally I can say this because I am short and have cash (“secondary investment capitol”) to spare. I’m not going to get a margin call. I can also say this because those who argue, “paper losses are still losses” are assuming that a cause will result in an effect. Like those who say, “Keeping a car in top shape guarantees you will be able to resell it for the top price.” Is that so? Of course it isn’t. It would be better to say that when the probabilities do not play out as expected then, assuming you are with the trend, you must wait longer for a profit.

Further, I entered the market on the primary election. When it morphs into one of the other corrective modes I am OK with that because a) I planned for it, b) the fractals[18] are my teacher – I’m not going to argue with them, c) I’m not “betting the farm,” d) the “Trend is your Friend” - so long as I’m with the trend I can sit it out, and e) I made my election based on the information I had - it was and always will be a question of probability, not certainty.

So I can feel confident I did the right thing with the information and education that was available to me – and get a good night’s sleep. There will always be that very select group of people who are better with the tools, have a better education, have more time, have insider information, or are just “gifted.” I cannot change any of those things.

What about stops? I don’t use them. There are plenty of traders out there who don’t use stops yet roll in 200-400K every year. Stops only take one thing into consideration: price. I don’t invest on the basis of price. Those who invest with stops state they would get killed without them. If that is so then they are probably using some sort of leveraged investment (e.g. margin). Also, they are probably not watching the market closely. Stops do just that: they make you think you are safe; they make you a lazy trader. People that use stops lose more money than those who do not. Simply put, trade well within your capitol and be willing to sit out the unexpected. This is a far better position, I believe, than playing a psychological mind game instead of technical investing.

Glossary

Tick: The “tick” reading is a real-time market indicator that shows the net total of the number of stocks last traded on an uptick minus the number last traded on a downtick.

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[1] See for an overview of their approach and services. The Short Term Update runs every Monday, Wednesday and Friday. It is sometimes referred to as “STU.” Elliott proposes that markets are driven by natural trends in mass psychology referred to as the “Wave Principle.” It projects a bear market whose magnitude has not been seen since 1720-1784 during which several depressions transpired.

[2] Going “long” on a stock is when you purchase the stock at a lower price in anticipation of a rise in its value.

[3] You can view the “idealized” future outlook chart for the S&P 500 by joining Club EWI (free after a simple registration) at .

[4] Use . Enter your stock of interest and the short interest rate will be listed along with other analysis under the Competition tab. If there is no Competition tab then the stock has no interest rate. A short interest ratio greater than 2% is considered an indicator that the stock’s price will rise. The rationale is that the large short position must be covered in the future and thereby creates buying pressure and drives the stock up.

[5] An option is the right, but not the obligation, to buy or sell a stock (or other security) for a specified price on or before a specific date. A call is the right to buy the stock, while a put is the right to sell the stock. The person who purchases an option, whether it is a put or a call, is the option “buyer.” Conversely, the person who originally sells the put or call is the option “seller.”

[6] The last depression should serve as a good barometer for us. - 2 -The average lengths of the 1930 to 1932 decline’s eight identifiable corrections was 34.5 days. The average percentage gain was 27.8% with an obvious bell curve – higher gain corrections were in the middle of the period.

[7] A margin account enables you to borrow money from the broker. It is available for you to trade so long as the margin requirements for that broker are met. As of the date of this writing Datek, for example, requires a minimum $2,000 balance in order to allow an account to be margin enabled. You do not have to use this money. Just ignore the “buying power” figure in your account.

[8] Strictly speaking deflation is a reduction of prices on a national level. The PPI (Producers Price Index) in July 2002 has already flashed warning signals that this has begun.

[9] One way to do this is to short the maximum amount of the offending stocks either at the current price, or the highest point of the current wave: whichever is most advantageous. This typically forces you to close your position before the end of the trading day but it raises the average price of the shares considerably.

[10] Elliott Wave Principle, Frost and Prechter; available from . While this volume is not necessary it is essential to those interested in becoming nimble in wave theory. It is often referred to in the Short Term Update.

[11] I.e. Having one logarithmic and one arithmetic scale. The logarithmic scale is the power to which a base, such as 10, must be raised to produce a given number. If nx = a, the logarithm of a, with n as the base, is x.

[12] $10,000 invested in the Dow since 1950 during the months May through October is now worth only $9056, an annualized loss of 0.4%. However, if you kept money in for all 12 months the same $10,000 invested during November to April would have grown to $459,917, an annualized gain of 15.2%. Monies invested solely during the Dead Zone from 1966-1982 bear market fell by a resounding 54.2% -- but that was before the effects of inflation. Factor inflation and the loss was 84.6%.

[13] Wall Street Journal. Compare articles dated July 13, 1994. July 10, 1996, February 11, 1997, April 9, 1997, May 13, 1998, November 5, 1998.

[14] Further, casinos typically provide a loud, social event attended by alcohol and other forms of entertainment. The serious investor wouldn’t dream of such an approach.

[15] Alan Greenspan gave a speech in Lueven, Belgium on January 14, 1997, in which he touted the Fed's obligation to bail out banks and private financial institutions, not just by printing unlimited amounts of money, but also through direct intervention in market events.

[16] 1 Timothy 5:18 in a context where the Presbytery’s income is stipulated.

[17]This was, in part, due to the shift in the advance/decline line in 1998. He presently states that, technically, the bear market did begin at that time.

[18] Market movements are in “waves” that reflect a fractal pattern. A fractal is a pattern that subdivides into smaller patterns of like design.

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