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Whether you are a beginner or experienced day trader, there are certain behaviors or rules of thumb that “trading gurus” advocate. For example, as I have previously discussed, many of these trading gurus place an inordinate emphasis on volume-weighted average price (“VWAP”) even though VWAP is often an unreliable indicator for day traders. The stickiness of simple rules of thumb like stocks under VWAP are always shorts and stocks over WAP are longs can veer many day traders off course. While they may feel like they have an edge, day traders who follow these rules of thumb are adding significant risks to their portfolios.
A stringent adherence to VWAP isn’t the only danger, however. Many online trading instructors are all too happy to short the front side of a move. Essentially, what these online trading instructors are doing is averaging their price up while shorting until the stock pulls back. Once it does, the traders are in profit. This can work 99 out of 100 times, but that 1 time it doesn’t work, it can wipe out all your gains and then some.
While this strategy sounds nice in theory, there are inherent dangers. By understanding those dangers now, you can potentially save yourself from substantial losses in the future.
Why Shorting the Front Side is Inherently Risky
There are several dangers to shorting the front side that often are brushed over by trading gurus or self-proclaimed trading experts. One of the most dangerous risks in shorting the front side—or shorting in any circumstance—is that your losses are theoretically unlimited. As you likely know, by going long, the cap on your losses is if the stock goes to zero. By contrast, to cover your short, you need to eventually buy back the shares that you borrowed to sell, and the stock price can theoretically rise forever.
Therefore, the ultimate risk in shorting the front side is that a stock never pulls back. It keeps going higher and never pulls back. Because you will eventually need to cover your short, you may suffer deep losses. If you hold your short for long enough and the stock never falls, you could theoretically wipe out your entire portfolio.
While this last scenario is unlikely, there are plenty of examples where shorting the front side has led to some ugly losses. You only need to look at a few charts to further understand the dangers of shorting the front side. For example, check out this first chart:
Here is another example of where shorting would have cause some significant damage.
I can go on and on. But ultimately, by shorting the front side, you are inherently engaging in one of the riskiest things that you can do while day trading. That is guessing rather than waiting for confirmation. Whether you are relying on a seemingly sophisticated analysis or simple intuition, estimating an imminent downtrend instead of actually seeing evidence of that downtrend is a fool’s errand. While it may feel “safer” in that you are lowering your average cost basis by continuing to short a rising stock, you are adding even more risk to the trade. And if there is a sudden short squeeze due to a rumor or actual news? Your portfolio will take a major hit.
Shorting the front side may seem like a smart strategy. In the short-term, it may work. But having said this, in the long-term, you will inevitably come across one trade where you continue to short a rising stock that never falls. You may be waiting for a negative catalyst that may never come.
Mitigate Your Risk
While it is fun to fantasize about potential day trading profits, day trading is equally about preserving the capital you already have. A strategy like shorting the front side of a move is inherently adding more risk to your day trades. Even though self-proclaimed day trading gurus may tout its effectiveness, I encourage you to look at the facts and come to a judgment yourself.
This analysis of the dangers of shorting the front side is a sample of what I speak about in my online course on day trading. The course has three modules that share a comprehensive day trading framework. The framework has led to proven results not only in my day trading career but in the day trading careers of my students. To learn more about the course, click here.