Fidelity Active Trader News article: "Hunting for Bears"

Friday, January 13, 2012

 

Searching for short-sale opportunities can be risky, but potentially rewarding.

Stability and strength are typically prized traits in a stock, but price volatility and weakness can also signal an opportunity to turn a profit—if you’re willing to go on a bear hunt. Bagging a bear presents a different set of risks than riding a bull, so it’s important to choose your target carefully. For Fidelity investors looking to spot a bear, the Bears in the Woods stock screen may be one approach that fits the bill.

The screen, developed for Fidelity traders by Recognia investment research, looks for opportunities to bet against stocks that are trending toward a significant price drop. Taking advantage of a downward-trending stock requires selling short: that is, selling “borrowed” stock at today’s price, then closing the deal by purchasing the stock at a future time. If the price drops between the time you enter the agreement and when you deliver the stock, you turn a profit. If it increases, you take a loss.

Short-term strategy

By definition, a short-selling strategy supported by the Bears in the Woods screen is also a short-term approach. Whereas a bullish stock theoretically has no upper limit, a bearish stock can fall only so far before hitting bottom. After a stock has undergone a significant drop, there’s not much incentive for short sellers to continue to hold their positions. There’s limited room for the stock to move lower, but it could bounce back and erase some of the spread.

“If your style is that of a long-term, buy-and-hold investor, this strategy isn’t for you,” says David Garrard, a Recognia vice president who developed the “Bears” screen. “It really is designed for someone looking for short-term opportunities, and it is relatively high risk. That said, there’s also the potential for relatively high rewards.”

Overvalued and above-average volatility

The primary filter on the Bears screen is a price-to-book ratio that’s in the highest 60% of the companies in a given industry. Price-to-book ratio compares a company’s market value with the net value of the assets on its books (how much money it could raise if it liquidated). A relatively high ratio, therefore, is a sign of potential overvaluation.

The Bears screen also looks for price volatility, which indicates that a stock has been prone to price swings that could increase the chances of executing a profitable short sale. The screen uses beta, a statistical measure that compares a stock’s performance with the overall market. A beta of above 1.0 shows that a stock fluctuates more than the market, so the screen eliminates stocks with annualized beta values of less than 0.9.

With the bears now in sight, the screen zeros in on those that are losing strength. To do so, it targets bearish candlesticks and multibar patterns, which are short-term technical indicators that can reveal stocks with significant weakness in their opening and closing prices, as well as their intraday price swings. The screen filters to make sure a stock exhibits at least one of these short-term bearish patterns, in the hopes that it might be one of the weakest in the pack.

Timing is important

“When stocks go down, they tend to go down faster than when they go up,” explains Garrard. “So you have to be ready and time your short sale carefully.” He believes that much of the early activity on a given day represents execution of large trade orders, and when that volume has cleared, usually by mid-morning, the true direction a stock is heading for the day may begin to emerge.

To determine whether a bearish candidate is poised for a downward move, the screen looks for a current-day drop in the range of 1% to 3%. This filter ensures that the day’s price has had some time to develop but has not passed the point where the majority of the decline may have already taken place.

“A trader could get in and out of a short sale on the same day, or could wait two or three days, depending on the stock’s performance and how he or she has fine-tuned his or her strategy,” Garrard says. “This is a strategy that requires you to have the time to check your stocks every day or even multiple times a day.”

Even if you check the market frequently, it might be wise, he says, to place a “trailing stop” order on your short sale to automatically lock in profits at a certain level.

Ways to mitigate risk

If you don’t mind taking some risk with a portion of your portfolio, but want to err on the conservative side, you might try tweaking the screen’s parameters. It already sets a 90-day average volume filter at 40,000 shares to guard against getting stuck with a stock that’s hard to unload, and a $5 price-per-share floor protects against large percentage swings resulting from small movements in the share price. You can adjust these values upward if you want additional risk mitigation in these areas.

Also, Garrard cautions that a bearish strategy works best in a bearish market. If the market turns bullish, even a weak stock can be pulled along by the upward current. But a volatile stock with indicators of weakness in an uneven market is a prime target for bear hunters, Garrard says.

Next steps

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