Northeast Utilities: Short Setup In Play

Jun.11.12 | About: Eversource Energy (ES)

I believe that Northeast Utilities (NU) will be heading lower for the short to intermediate term. I also believe that it has been extensively distributed over the last few weeks.

As is the case with any utility, Northeast Utilities it is a slow but consistent mover. If you examine the chart below, you can surmise that it has been trading in a sideways range-bound pattern since the early part of the year. I expect that pattern to continue over the next three to six weeks. There is a high probability it will decline back to the lower levels of the range and possibly lower.

Northeast Utilities is at an all-time high, and this is in conjunction with the largest blocks trading since December 2010. This indicates that Northeast Utilities has been extensively distributed by the Designated Market Maker in this issue, as well as other exchange insiders. I also believe that window dressing (a topic I have been writing about quite a bit) will also be a contributing factor to a slight advance prior to the decline.

If the Designated Market Maker has an extremely large block or series of blocks to unload at a top, he may use an insider institution as a distribution channel to distribute the stock. I believe this is part of the process being conducted now. This would explain why the stock has continued to advance a few more points to offer incentives to the institution, as well as induce the unsuspecting hapless small investor into buying. Once the the distribution phase is completed, the Designated Market Maker sells short and the small investor eventually will be the one left standing without a chair when the music stops. That is to say the small investor will concede his or her position at much lower price levels.

Whenever I hear that institutions are buying heavily at a long-term high, I suspect that a reversal is not only imminent but already been put into motion.

To reiterate: Northeast Utilities will continue to advance for the short term, which gives the impetus for the institutions to sell them off as the "stock du jour" to the small investor. Once it is distributed to the investing public, the DMM will short the issue, drop the price, covers his short positions and once again accumulate at strategic price points during the sell-off that follows.

It is critical for investors to understand that Designated Market Makers raise and lower prices in accordance to whatever their inventory objectives dictate. If he is low on inventory, he needs to accumulate stock. This in turn leads to his needing to distribute that he has accumulated. Once the Designated Market Maker distributes all of his accumulated stock, he sells short. He sells short in order to profit on the downside of the market. He never misses an opportunity to profit anywhere in the merchandising cycle.

Click to enlarge images.

Click to enlargeIf the Designated Market Maker wishes to distribute a stock that he has accumulated, he raises the price thereby creating demand. In the reciprocal, if he wishes to accumulate a stock he has distributed he lowers the price because when he does, the investing public sells. This is how he initiates each phase of his merchandising cycle, and once again the investing public responds to the stimuli like Pavlov's dogs.

It is a buy/sell cycle that plays out over and over and over again. All made possible by the fact that it is rising prices that create demand, and that the DMM has unilateral control over price.

Click to enlarge

On the basis of the foregoing, these are my views and observations:

The Trade

I recommend establishing a short position in Northeast Utilities. Open your position with only one-fourth of whatever capital you intend to commit to Northeast Utilities at $37.75. Purchase the remaining three-fourths of the position at $40.77 and stop out at $42.37. Do not post your stop out. I have said it before, but it is so important that at the risk of being redundant and in an abundance of caution I will say it again. It is too easy for the Designated Market Maker to cash investors out by moving the price above or below your stop out and move the price right back down or up again.

In addition, when a stop out is triggered it converts into a market order, and that could be disastrous if the Designated Market Maker decides to really take advantage. Remember the "Flash Crash"? I would be looking to exit the trade at a downside price target of $34.73. Do not allow this position to exceed 5% of your overall portfolio.

There is always the possibility that the trade may not work out.

There Is Never A Sure Thing (Particularly On A Short)

Investors must realize and recognize that there is never a sure thing. Sometimes events that have a low probability of occurring bring forth very serious consequences should they come into being. Investors must judiciously consider what the inherent practical limits are and how much they stand to gain in relation to the risks involved in establishing any position. In addition, persistence can become desperate folly by allowing a losing position to become a viable argument for deciding on a new position. Rather, such decisions should be based on the current and soon-to-be circumstances.

Any position in which one unexpected factor has a significant impact on your portfolio is the result of poor planning. It is a fault most commonly associated with people who want to explain away their losses. As Sun Tzu said in The Art of War: "Use an attack to exploit a victory, never use an attack to rescue a defeat."

If you follow the process recommended and the trade does not work, the overall loss in this model is $3,000.00. That amounts to 0.003 of the overall portfolio (theoretically valued at $1,000,000).

And finally, never be a brave and brainless investor because a fool and his money are soon parted.

A portfolio of $1,000,000 should position size in the following manner:

This is a trade, not an investment. Be ever vigilant.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in NU over the next 72 hours.