Tuesday, August 27, 2013
Trying to pick the top of a stock is often a dangerous and expensive exercise. Just ask anyone who has shorted shares of Tesla (TSLA) this year...
The electric car company's stock is up about 400% in 2013. At about $165 per share, the stock is trading at fundamental valuations that rival those of the dot-com era. This has a lot of folks looking to profit when the TSLA bubble pops.
The stock is one of the most popular targets for short-sellers. More than 31% of the outstanding shares have been sold short. So there are plenty of traders looking to profit on the downside.
So far, though, rather than rolling in profits, TSLA short-sellers have been run over. Take a look at this chart...
Clearly, there's some euphoria surrounding the stock, and there's some hype driving the price to obscene levels. But hype can last a long time, which makes it dangerous to short a stock based on valuation alone.
It's far better and safer to wait until the technical trend turns lower. Wait until the chart breaks down and then bounces back to test the breakdown level.
For example, take a look at this chart of another overvalued stock, Salesforce (CRM)...
At $44 per share, CRM trades at 82 times next year's earnings estimate, 10 times book value, and more than seven times sales. By almost every measure, it's a fundamentally bloated stock. But anyone trying to short the stock earlier this year would have suffered as CRM held its lofty levels.
Notice, though, how the stock broke down from a rising-wedge pattern back in May. This was the first sign of technical weakness in the shares. Aggressive traders could have tried to short the stock as it fell through the support line of the pattern, and the chart switched from bullish to bearish.
But that was a fast move. Shares tumbled 10% almost overnight and the stock was oversold before most traders could hop on board with a short sale.
Selling a stock short into oversold conditions is just as dangerous as trying to pick the top of a stock. You almost always get a sharp bounce that relieves the oversold condition, punishes anyone who tried to short the stock too soon, and retests the breakdown point on the chart.
The ideal time to short a stock is on that retest of the breakdown point.
Take another look at the CRM chart. You can see the strong bounce that brought the shares all the way back up to retest the former support line of the wedge pattern. That gave short-sellers a terrific, low-risk setup to short the shares.
The former support line is now resistance. If it holds, then the stock should turn lower and short-sellers could profit almost immediately. If the stock rallies above resistance, then short-sellers can stop out of the trade for only a small loss.
Traders need to be patient enough to let the right setup come together. It takes time for good charts to turn bad. Don't fight the momentum of a strong uptrend. And don't short stocks into oversold conditions.
Wait for the chart to break down and then retest the breakdown level. You won't have to suffer through the euphoria of a hype-inspired move, like we're seeing now in TSLA. And you'll often still be able to short the stock near the high of the year – like we saw with CRM.
Best regards and good trading,
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