Things I look for in a short…..
With the recent direction of the market, chances are you were short and making money or you were long and most probably losing it. In light of the market’s direction and considering the fact that 3 of 4 stocks mentioned here lately have been short positions, I thought I’d post a little of what I look for in a short setup/position. There are many different setups, but in my experience and for my style, I have found a few components to be key.
Volume is the most important indicator you’ll find on a chart. I suspect it is also the most underrated. There is a saying “volume precedes price”. This means often before big trouble starts, you’ll notice an uptick of volume on down days. It doesn’t have to be a huge spike either, it can be 30 or 40% above average daily volume. Most short setups will have volume as a key component. Quite often recently, you’ll see a trending stock just crash through a trend line or one of my favorites-a 50 day moving average. Some people will jump right into a short at that point and look for the momentum trade, I prefer to enter after 1) a major moving average or a trend line is broken on significant volume and 2) there is an attempt to rally back up toward that trendline or MA. This rally MUST occur on light, diminishing volume-preferably less than average daily volume. What this does is 1) confirms the weakness as price can’t get back above the trend and 2) puts me in at a level that is very close to a reasonable stop. At this point I’ll look for a reversal signal to actually enter the short sale. These reversal indicators can include: dojis, engulfing, harami and dark cloud cover candlestick patterns (if you aren’t familiar with candlesticks, I highly suggest reading Japanese Candlestick Charting Techniques by Steve Nison. So in recapping this setup 1) A break of an important trend on good volume. This trend can be represented by a moving average (most commonly a 50 day), a price channel including linear regression or a common trendline (so long as it’s drawn correctly, 2)An attempt to rally back up to that trend on significantly less volume 3) A reversal signal on a daily chart to signify an entry.
Another concept in short selling is that of top patterns. Top patterns usually take a few weeks to a year or so to develop. Most commonly they are within a 6 week to 3 month period. I certainly can’t go into depth with regard to all these patterns, but it is worth mentioning a few notable ones. Probably most often cited and recognizable is the Head and Shoulders top, click on the link for a past post covering them. There are also Rounding tops, Triple tops, Broadening tops, and a few others. You can find a pretty comprehensive treatment of all of them in Technical Analysis of Stock Trends.
Some of the indicators I use to help spot weakness in a stocks chart are proprietary to Worden Brother’s Telechart. They include MoneyStream, Time Segmented Volume and Balance of Power. Other indicators that attempt to identify trend quality and money flow include On Balance Volume, ADX, Accumulation/Distribution on Line, Chaikin Money Flow, Chaikin Oscillator and Money Flow Index. I use the Tele Chart indicators, but whichever you use, you must be aware of the indicator’s strength and weakness. For example, some of these indicators will not perform well on stocks that are components of a major index. As ETF or funds that are tied to indexes try to mimic the index performance, the buying and selling activity associated with that tends to color the results. There are other situations as well, but it should be said of all indicators-you must know them and how they are expected to perform. It is also very useful to look for confirmation in the indicators with volume and price patterns. MACD is for me, a very important indicator and it is most often used to measure trend quality. For instance, if I’m seeing the completion of a head in what I believe may become a Head and shoulders formation, it is too early to be certain that it will form that pattern. However, should there be a negative divergence in MACD, I know something is up and that it may very well be that the trend is done. In another example, if I were to see a chart that was trending up well, but a negative divergence has formed in both MACD and perhaps one of the accumulation/distribution indicators as it made a new high and then it broke down through a 50 day moving average-I would be on alert for a promising short setup. I would certainly look for a rally on light volume back up to the area of the 50 day moving average for an entry. One of my favorite combinations of indicators is TSV/MS/BOP with MACD and a negative RSI reading. So in summarizing this segment-know your indicators, their strength and weakness. You don’t need a lot of indicators, as a matter of fact I’d pick a handful that you have found to be reliable and that you understand. Look for confirmation between price, volume, and the indicators. Above all, be patient. The right setup will come, but if you have blown your money and confidence on a bunch of sub-standard trades, you’ll not be in good shape to take advantage of the really good setups.
It is important that you match up your indicators with your particular trading style. I happen to be position trader/trend trader. If you are a day trader you’ll use a different set of tools than if you are an investor or even a swing trader. For position trades I happen to think a 50 day moving average is very useful. I also like a 10 and 20 or 22 day moving average crossover system. For instance, you go long when a 10 day ma breaks above a 20 day ma with good support in volume and a positive RSI and maybe a few other indicators confirming the strength. Likewise you may consider shorting as a 10 day ma crosses below a 20 day ma on decent volume with perhaps a negative RSI reading. Traders who are closer to investors may like to use a 50 day and 200 day average as a substitute. In any case, understand your strengths as a trader and where you have a weakness and try and setup your chart to help you trade in your strong areas.
Finally let me say one of the most important concepts in investing/trading is “The trend is your friend”. Sure we’ve had some great successes on the short side recently, but that largely was because we were investing in the direction of the trend-the market was making it easy. That is a key concept. Often when the market is trending up, I’ll be in roughly 75% long positions and 25% short. As the market enters a reversal or a sideways period, I’ll either reduce my exposure or be 50/50. When the trend reverses, I’ll be 75% short and 25% long. I must admit for a host of reasons, I do like being short more than I like being long. I will include a few charts with notation on Trade Guild’s sister site–Chart Requests, be sure to check them out. Also, very important that you review the posts on Stops, the 2% Rule, Selling Short and Position Sizing. No matter what your tactic, money management is what sets you apart from average traders.