analytic method.Question 99—The Short Interest RatioThe Short Interest Ratio reflects the intensity of shorting by measuring:1. The number of shares held short by the bears relative to the “freefloat.”2. The number of stocks shorted by a trader relative to the number ofshares he bought.3. The number of traders holding shorts relative to the number oftraders holding longs.4. The number of traders whose accounts are set up for shorting relative to the total number of traders.Answer: 1The Short Interest Ratio compares the number of shorts held by thebears with the “free float” in any given stock. The free float is the number of shares available for shorting—the total number issued by thecompany minus restricted stock granted to executives, held by “strategic shareholders,” and insiders’ holdings. Brokers report the number ofshares that have been shorted and not covered. If you divide that number by the total free float, you’ll have the Short Interest Ratio, reflecting the intensity of shorting in any given stock.
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Question 100—Trading the Short Interest RatioTracking the Short Interest Ratio can help a trader in all of the following ways, except:1. A rising Short Interest Ratio confirms a downtrend.2. A Short Interest Ratio over 20% warns that the stock is liable to havea sharp rally.3. A Short Interest Ratio under 10% means that shorting is relatively safe.4. A falling Short Interest Ratio calls for a break in the stock.Answer: 4When the Short Interest Ratio rises, it shows that bears are becoming angrier and louder. Every short position must eventually be covered, and those short-covering rallies are notorious for their speed. Asan estimate, a Short Ratio of less than 10% is likely to be tolerable,while a reading of over 20% marks a suspiciously large crowd of shortsellers. The Short Interest Ratio tends to increase as the stock slides andmore bears join the party. The Short Interest Ratio tends to decline during the uptrend; such uptrends can last for a long time.Question 101—Markets Need ShortingWhich of the following markets could exist without shorting?1. Stocks2. Futures3. Options4. ForexAnswer: 1While only a small minority of stock traders sell short, the volumeof shorting in futures, options, or forex is exactly equal to that of buying. For every contract bought there is a contract sold short—total longand short positions are absolutely equal in every trading vehicle exceptstocks.
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Question 102—Who Shorts FuturesMost shorts in the futures markets are being held by:1. Public speculators2. Commercials or hedgers3. CFTC4. Hedge fundsAnswer: 2Most shorts in most futures markets are held by the commercials orhedgers who are the true insiders. For example, a major agribusinessmay sell wheat futures to lock in a good price for a harvest that has notyet been gathered. But that is only part of the game. Any hedger worthits salt runs its futures division as a profit center and not merely as aprice insurance office. They expect to make money on those positions.Question 103—Shorting FuturesFind the incorrect statement about shorting futures:1. A seller enters into a binding contract for future delivery.2. The floor for a commodity price is defined by its cost of production.3. Insider trading is illegal in futures.4. The ceiling for a commodity price is defined by the cost of substitution.Answer: 3When you trade futures, you enter into binding contracts for a futurepurchase or sale of a commodity. All trades are backed by margindeposits on both sides. Futures, unlike stocks, have natural floors andceilings. The cost of production creates a floor and the price of substitution a ceiling. Those levels, however, are somewhat flexible ratherthan totally rigid. In futures, there is no prohibition against insider trading because hedgers are the true insiders. You can track their behaviorthrough “commitments of traders” reports, regularly published byCFTC.
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Question 104—Long Rallies and Sharp BreaksWhat is the main factor that makes many commodities prone to steadyincreases, punctuated by sharp declines?1. Carrying charges2. Manipulation3. Seasonal factors4. Cost of substitutionAnswer: 1Commodities incur carrying charges, as the cost of storing, financing, and insuring them gets worked into their prices. As all of thesecharges keep adding up month after month, prices could graduallyclimb to unrealistic heights. What happens instead is that relativelyslow and steady price increases get punctuated by brief violent drops,returning prices to realistic levels—and then the process begins again.Question 105—Writing OptionsWhat is the main reason that options writing is much more profitablethan buying?1. The time value of options2. Most buyers are undercapitalized.3. Options move differently that stocks.4. Most buyers are beginners.Answer: 1The key difference between options and stocks is that options arewasting assets. While all the factors listed in the question contribute tooption buyers’ mortality, the wasting time value of options is the mostimportant among them. As the clock keeps ticking towards optionexpiration, it reduces the value of an option: the buyer keeps losingmoney, while the writer (seller) is more and more secure in his possession of the money received from the buyer.
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Question 106—Writing Covered OptionsWhat is the main disadvantage of writing covered options?1. If the stock stays flat, you will have no capital gain in it.2. If the stock falls, your long position will lose value.3. If the stock rises above the exercise price, it will be called away.4. Covered writing requires large capital.Answer: 4If the stock stays relatively flat and does not reach the option’s exercise price, you will pocket the premium, boosting your total return. If thestock falls, you will also pocket the premium, cushioning the fall of yourstock. If the stock rises above the option exercise price, it will be calledaway. You’ll keep the premium in addition to the capital gain from thepurchase price of the stock to the exercise level. Since there is a big universe of interesting stocks, you can take your freed-up capital and lookfor new opportunities. The fact that one needs substantial capital to purchase shares against which to write options in a large enough size to makefinancial sense, prevents most traders from getting into this business.Question 107—Naked vs. Covered WritingWhat is the main difference between naked and covered optionswriting?1. Trade duration2. How the trades are backed3. Trade size4. The analytic techniquesAnswer: 2While conservative investors write covered calls against their stocks,naked writers create options out of thin air, backed only by their cash.This backing for the trades—either by shares or cash—is the key difference between covered and naked writing. The differences in otherareas are minimal or non-existent.
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Question 108—The Demands of Naked WritingThe greatest demand that naked writing of options places on traders is:1. Cash2. Trading ideas3. Discipline4. TimingAnswer: 3Naked writers walk a narrow line, protected only by their cash andskill; they need to be absolutely disciplined in taking profits or cuttinglosses. You cannot write options without sufficient cash, and you needto have good ideas and good timing. Even if you are excellent in thoseareas, you must have perfect discipline to succeed.Question 109—Brokers Against TradersIn the following list of venues for trading forex, where does a broker’sprofit usually depend on a trader’s loss?1. The interbank market2. Currency futures3. Holding foreign cash4. Forex trading housesAnswer: 4Most forex houses operate as bucket shops—rather than transmityour orders for execution, they take the opposite side of any trade,whatever you want to trade, either long or short. When you trade inthe interbank market, buy or sell currency futures, or simply exchangecash, a brokerage house does not care whether you make or losemoney. They execute your orders and collect commissions. On theother hand, most forex shops bet against their own customers on everytrade. When their clients lose, the shops make money.
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Question 110—Forex MarketWhich of the following does not apply to the forex market?1. It is one of the most trending markets on a long-term basis.2. It is largely driven by the fundamentals of government policies.3. It is easy to plan and enter trades in forex.4. It trades essentially 24/7.Answer: 3Any time a salesman tells you that something is easy in the market,run the other way! Yes, forex trades 24/7, but this means that a tradewhich you have carefully planned may come together on the other sideof the globe while you are asleep. Once a currency gets into a majortrend, whether up or down, it might stay in it for years, due to the factthat in the long run the value of a country’s currency depends on government policies.Question 111—Learning to Become a Better TraderThe most important factor in learning to become a better trader is:1. Researching the market2. Keeping good records3. Finessing your entry and exit techniques4. LuckAnswer: 2The single most important factor in your long-term success or failure is the quality of your records. Keeping and reviewing them willallow you to improve your research and trading techniques. The harderyou work, the luckier you’ll become.
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Question 112—Trading Signals of Force Index
Figure 3.112
On the chart above, you can see that the downspikes of Force Index(marked by solid arrows) tend to be followed by price bottoms the following day. The chart also shows that the upspikes of Force Index(marked by dashed arrows) tend to be followed by the continuation ofthe uptrend rather than a top. These differences indicate that:1. This indicator works only in downtrends.2. This indicator works only in uptrends.3. Uptrends and downtrends are not symmetrical and have to betraded differently.4. One can base a trade on a single indicator in a bear market.Answer: 3Uptrends are driven by greed and tend to last longer. Downtrends aredriven by fear; they tend to be more intense but last a shorter time. Thisessential asymmetry of tops and bottoms means that while the generalprinciples of chart reading remain the same, selling short requires sharpertiming. A single indicator is never enough; a trader must look for confirming signs—for example, a spike occurring while the price hits thechannel line. A short-seller cannot afford to give his trade more time to“work out.”
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Question 113—False Breakouts and Divergences
1A
B
C
D
E
Figure 3.113
Please match the letters on the chart to the following descriptions:1. False breakouts2. DivergencesAnswer: 1.2.
B, C, and EA and D
Tops and bottoms tend to be asymmetrical. Technical signals, suchas false breakouts and divergences can provide signals to sell short aswell as to buy, but the timing is likely to be different. Notice, for example, how a false downside breakout was over in a day, while each ofthe false upside breakouts lasted for three days. It is harder to placestops on shorts; two days beyond the right edge of this chart the stockstabbed to a new high before collapsing; a tight stop would have ledto a whipsaw.
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Question 114—Shorting and Covering SignalsB
DEGI
A
K
FHC
J
L
Figure 3.114
Please match the letters on the chart to the following descriptions:1. Pullbacks to value2. Undervalued zone3. Kangaroo tails4. DivergencesAnswer: 1.2.3.4.
E, G, I, and KA, F, H, J, and LA, B, and DC
When you find a stock traveling in a well-defined down-slopingchannel, you can sell short at or above value, as defined by the moving averages. You can cover whenever prices fall to or below theundervalued area, defined by the lower channel line. Like many otherpatterns, kangaroo tails work near the bottoms as well as near the tops.
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Question 115—Shorting Tactics
Figure 3.115
Please select the tactic to follow for the next few weeks at the rightedge of the chart:1. The trend is up—buy here, near $94.95.2. The trend is up—buy on a breakout above the recent peak of $100.50.3. The Impulse system turned Blue with the downtick of MACD—sellshort, with the target of $87, near the fast EMA.4. The Impulse system turned Blue—sell short with a target of $81,near the slow EMA.Answer: 3This stock is in a powerful bull market, but no trend goes in a straightline. The place to buy is near value, but now prices are overextendedabove value. With the MACD-Histogram ticking down and the Impulseturning blue, while the Force Index is showing a bearish divergence,shorting becomes an attractive option. The fast EMA is a realistic target;if and when prices approach that target, a trader may re-evaluate the situation and decide whether to cover or to hold.
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GRADING YOUR ANSWERS
If a question requires only one answer, you earn a point by answeringit correctly. If a question requires several answers (for example, “Whichtwo of the following four statements are correct?”), rate your answerproportionately. If you answer both correctly, give yourself a point, butif only one, then half a point.25–29: Excellent. You have a good grasp of selling short. The markets await you. Be sure to keep good records in order to learn fromyour experience.21–24: Fairly good. Successful trading demands top performance.Look up the answers to the questions you’ve missed, review them, andretake the test in a few days before moving on to the next section.Below 21: Alarm! Being below the top third in your answers is a signof great danger in trading. Professional traders are waiting for you inthe markets, ready to take your money. Before you do battle withthem, you must bring yourself up to speed. Please study the third section of Sell and Sell Short and retake the test. If your grade remainslow on the second pass, look up the books recommended in that section and study them. Avoid shorting until your performance on this testhas improved.
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N
ow that you have worked through this Study Guide, what shouldbe your next step or steps?I hope that the key concepts in Sell and Sell Short and in this StudyGuide have become ingrained in your mind:• Every trade deserves a plan: when you decide to buy, you needto plan when and where to sell. A trade without a selling plan isa gamble.• The markets move down as well as up: learn to sell short and takeadvantage of the downmoves instead of feeling victimized bythem.• Practice money management: risk control is just as important asmarket analysis. Never overtrade, and when in doubt, trade asmaller size or stand aside.• Keep a trading diary and keep reviewing it in order to learn fromyour successes and failures.Now start implementing the ideas of Sell and Sell Short and of thisStudy Guide in your own trading. Please do not rush—so many beginners make the fatal mistake of trying to make a lot of money in a hurry.They put on trades that are too large for their accounts, become stiffwith tension, their decision-making suffers, and they lose. If you learnto trade a 10-share lot, you will know when the time is right to moveup to 50-share lots, and then to 100 shares, to 1,000, and even 10,000shares at a clip. Learn to trade a small size and move up slowly.Quickly reduce trade size after a string of losses to protect yourself.131
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Anyone can buy a stock, but you must sell and sell well to book aprofit or cut a loss. Once you learn how to sell, move on to short-selling to take advantage of the markets’ downmoves.Trading is an old man’s game, and now increasingly a woman’s.Experience matters, but to profit from it you have to stay in the gamelong enough. You need to set up a system of money management andrecord-keeping to survive the dangerous early stages of growth anddevelopment. At the risk of repeating myself, I’ll say yet again: “Showme a trader with good records, and I will show you a good trader.”If you would like to stay in touch, please visit www.elder.com andsign up for our free newsletter. About once a month I put my thoughtsinto an e-mail and send it out to clients and friends. The topics of selling and shorting often emerge in those letters.Trading the markets is the most exciting and engrossing pursuit.I wish you success.Dr. Alexander ElderNew York City, 2008
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ABOUT THE AUTHOR
Alexander Elder, M.D., is a professional trader and a teacher of traders.He is the author of Trading for a Living and the Study Guide forTrading for a Living, considered modern classics among traders. Firstpublished in 1993, these international best-sellers have been translatedinto more than a dozen languages and are being used to educatetraders around the world. His Come into My Trading Room: A CompleteGuide to Trading was named a 2002 Barron’s Book of the Year. HisEntries & Exits: Visits to 16 Trading Rooms was named a 2007 SFOMagazine Book of the Year. He also wrote Rubles to Dollars: MakingMoney on Russia’s Exploding Financial Frontier and Straying from theFlock: Travels in New Zealand.Dr. Elder was born in Leningrad and grew up in Estonia, where heentered medical school at the age of 16. At 23, while working as aship’s doctor, he jumped a Soviet ship in Africa and received politicalasylum in the United States. He worked as a psychiatrist in New YorkCity and taught at Columbia University. His experience as a psychiatrist provided him with unique insight into the psychology of trading.Dr. Elder’s books, articles, and reviews have established him as one oftoday’s leading experts on trading. Many of his own trades are featuredin this book.Dr. Elder is the originator of Traders’ Camps—week-long classes fortraders. He is also the founder of the Spike group, whose members areprofessional and semi-professional traders. They share their best stockpicks each week in competition for prizes among themselves. Dr. Eldercontinues to trade, conducts webinars for traders, and is a sought-after
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speaker at conferences in the U.S. and abroad. Readers of this bookare welcome to request a free subscription to his electronic newsletterby contacting his office:elder.comPO Box 20555, Columbus Circle StationNew York, NY 10023, USATel. 718.507.1033e-mail: info@elder.comwebsite: www.elder.com
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