Short seduction: Going down with the bear

May 24, 2016 09:00 AM

Over a century ago, Edward James Smith, the captain of the Titanic, ignored the warnings about icebergs in the Baltic Sea. Many warned him about the limits of the ship’s ability to make sharp turns due to its over-powered engines and small rudder, a deadly combination in the event of an oncoming iceberg. He sealed the ship’s fate and set a date with infamy that would last over the next 100 years.

Even worse, lack of planning by the ship’s designers doomed its passengers far earlier when the decision was made to include just a small number of lifeboats and emergency equipment. Their arrogance caused them to assume that the safety equipment would never be needed anyway.

The costly lessons of the Titanic stress that a lack of planning and the inability to change course quickly can lead to disaster. The same lessons apply in trading.

Bull markets can power forward, but when the bears suddenly appear, you have to have a nimble plan in place.

Sudden change in course

Many traders learn how to go long but few learn how to sell or short the market. This is a bit like a boxer learning how to punch but never learning defense. Everything is fine in a fight until you get hit with an unexpected shot. Now you have to cope with being hurt while not knowing how to stop it. If you continue getting pummeled, you may find yourself at the mercy of an unforgiving opponent in the form of the stock market. 

The birth of a bearish market is marked by explosive price movement that might leave you feeling as if you were hit by a haymaker. Dazed, confused, scared--these are some of the aftereffects of a bear market that traders might feel.

While bullish markets may take three to five years to register gains, bearish markets can almost completely wipe out the bull’s gains in just one to two years. Consider for a moment that you’ve spent up to five years racking up passive long gains in a bullish market only to lose it in a fraction of that time.

You’re not only at the mercy of a terrible opponent — the bear — but you have no ability to save your hard-earned gains. Worse, a lack of skill and preparation will leave you without a way to counter-attack or change course.

Shorting the market

When a stock’s bullish trend is on its last legs you can spot where its price action is beginning to falter just before it falls apart.

It’s at this point where your greatest opportunity lies if you’re prepared, and where the great short setup develops. 

The great short setup breaks down as follows:

  1. Identify a stock that has had a big run-up (an extended trend).
  2. Identify when it pulls back and whether that stock attempts to resume its trend.
  3. Suddenly, it experiences a steep sell-off or displays a downward gap on heavy volume.
  4. Afterward, see if the stock tries to recover and trade upward through its 50-day or 200-day simple moving average (SMA), but on lower volume.
  5. If the stock fails to trade above the 50- or 200-day SMA, then short it.

The 50-day and 200-day simple moving averages (SMA) aren’t just common technical indicators, but are closely followed by institutional traders. When the 50-day and 200-day are in the proper order, you easily can spot price trading above the 50-day SMA, which is trading above the 200-day SMA. When these pieces of the puzzle are in place, then you can tell that the bulls have control of the market and the conditions are in place for a bullish trend (see “Trend change,” below).

But when these SMAs are out of place or begin to show signs of getting out of order, then the underlying bullish trend is in danger. 

A counter-move can start to brew underneath the superficial appearances in place, and the dynamics begin to shift.

This is important to keep in mind because when the institutions on Wall Street start to see the tides shift, they will become defensive and start taking counter-measures to protect themselves. This usually comes in the form of mass selling or repositioning portfolios to avoid falling victim to heavy losses once the baton gets passed from the bulls to the bears.

When price falls below the 50-day or 200-day SMA, it sets alarm bells off along Wall Street and the market goes on high alert. At times, institutional traders will try to prop up price by taking new long positions that act as a fail-safe and can reboot the bullish trend. At other times, it’s a head-fake to boost price temporarily so that they can turn around and sell into the rally to get out at better prices. It’s at this point where opportunity presents itself for the skilled short-seller (see “Sudden shift,” below).

This is the first phase of the setup.

The jagged path

Once you understand how to spot when the market is in trouble, then you need to understand what is likely to follow.

Trends easily are spotted by observing their recognizable price patterns. For bulls, you can observe bullish trends by a steady series of higher highs and higher lows. For bears, you can recognize a steady series of lower highs and lower lows in the price action.

But when a bearish trend is first birthed out of an established bullish trend, its price action is jagged. Marked by a forceful decline, it’s followed by a sharp pullback and then a steep price decline. It’s at this point where the maximum profit potential lies for a skilled short seller who has a plan in place to take advantage of the new trend.

This is the second phase of the setup.

Even more important is that you understand this sequence of events because new bearish trends move at twice the speed as bullish trends. While bullish trends last longer, new bearish trends offer the opportunity to make big returns in less time, but only if you’re prepared. If not, then you’ll miss the new move and, worse, if you’re in a long position and fail to recognize the changing tide, you could experience an unnecessary and preventable loss.

The trigger

When a stock pulls back on lower volume, this is a sign that its price action is trying to recover but is ripe for a take-down by the bears. It’s like a boxer who takes a powerful blow, gets knocked down but beats the count to get back into the fight  (but his legs are still wobbly). The opponent senses he is hurt and attacks to score a knockout.

During this low-volume pullback, as the bears resume selling off the stock, you want to join in; shorting the stock begins the next downward leg of its journey (see “Gap setup,” below). This puts you on the winning side of the new bearish trend while taking advantage of the downward momentum. 

The final phase

The final phase of the setup is managing the trade itself.

A good rule of thumb would be to limit your risk to 2% of your total trading capital and then take half your profits at three times your initial risk point while moving a trailing stop on the remainder of your position to breakeven. 

Also, it’s important to keep in mind that this technique can help you identify when a stock is topping out, but the great short setup doesn’t happen often. It’s important that you regularly scan the market for high-flying stocks, usually daily.  Watch for stocks that have not experienced a 20% correction or greater in the last year or so, because when the time comes that they are due, their upward trends could end up in a free-fall.

Another good hunting ground also would be stocks that are issuing new shares. A new share issue could mean that they are diluting current shareholders’ equity, which is not a good sign for bulls. 

Also, look for stocks that are taking on debt or missing their earnings estimates. If a stock has missed an earnings estimate, Wall Street may overlook it, but if it misses a second estimate then doubt may creep in, leading to a potential sell-off. Any of these events is a sign of trouble for the stock, but for a smart short-seller they also are opportunities in the making.

About the Author

Billy Williams is a 20-year veteran trader and publisher of www.StockOptionSystem.com, where you can read his commentary and a report on the fundamental keys for the aspiring trader.