Stocks that make strong moves on a news item are an excellent shorting opportunity. The main fundamental theme to remember on shorts is that volume is the lifeblood of momentum and price acceleration. Always check the average daily volume and then compare it with the current volume on the day of the overblown run-up. When volume dies, so does the stock.
Another constant that appears to be predictable is that end-of-the-day profit taking occurs on stocks that make big gains throughout the day. The logic is very simple in that most traders do not want to keep a position overnight. They want to end the day “flat,” meaning all cash. These profit takers usually show up during the last 15 to 30 minutes of the trading day, depending on the market conditions.
On the flip side, many buyers will also show up at the end of the day in anticipation of a “morning gap” (having a stock open higher than where it closed the prior day). Therefore, as a short, you are looking to gain from the profit takers and yet avoid the end-of-the-day morning gap players. This makes shorting more of an art than a science.
The question is, how does one gauge whether the profit takers will outnumber the morning gapers? The answer lies with the overall market indicators. As a rule of thumb, try to take firm short positions slightly off the intraday highs on stocks when it appears that the market itself is either pulling back or going negative (see Short Selling 101 for more information on shorting a stock). This is usually enough for the traders to be panicked into locking in their profits for the day.
Stock News Significance
Another, lesser, concern is based more on fundamentals:
Significance of news is a major factor that will convince a trader or investor to hold onto a stock in anticipation of further stock appreciation. Usually, the best shorts are run-ups on biotech stocks based on research news, clinical findings, and PDA approvals. These biotech stocks will usually rocket up on news and sell off even faster when the profit takers come in. The reason traders are so quick to jump on and off biotech stocks is that news, while significant, will not affect the bottom line for months or years to come, and so the stock is usually considered dead money until revenues and profits are affected.
Volume equals Momentum
Positioning is the key element in successful trading.
One key point to remember is that as volume dies, so does the momentum, and that takes the price back down. We suggest that you find the average daily volume in the stock. Normally, these run-up stocks are moving on momentum of over 10 to 20 times the average daily volume. Taking a short position in these stocks is not a bad idea so long as you know that the volume will eventually drop back down and so will the stock.