Because fear is a more powerful human emotion than greed, stocks nearly always fall much faster and more violently than they rise. As such, there are key technical differences in our trading strategy with regard to the price levels where we look to sell short stocks, compared to the ways in which we buy stocks. In this article, we summarize our basic trading strategy for determining the most ideal, low-risk entry points for short selling stocks and ETFs.
Since our rule-based system for market timing switched to a new "sell" signal on October 12, our swing trading focus is now on selling short weak stocks, rather than buying stocks with relative strength to the broad market. It is crucial to realize that trading in the same direction as the dominant broad market trend is, and has always been, the first and most important element of our swing trading system.
Presently, the majority of stocks we are monitoring for potential short sale entry have either set a new "swing low" within the past few days, or are trading too close to a prior low, to initiate a low-risk entry point at current levels. We do not sell short stocks that are breaking down below obvious levels of support, as they tend to rebound and rip higher after just one to two days of weakness.
Our most ideal short selling candidates are stocks and ETFs that have recently set new "swing lows" (or are testing prior lows), and have subsequently bounced into resistance over a period of three to ten days. But even though we prefer to wait for a bounce before entering a new short position, it is important to realize we do not enter a new short position while the stock is still bouncing (trying to catch the high of the bounce). Rather, we first wait for subsequent confirmation that the stock is about to stall again. This typically comes in the form of either a bearish reversal bar (such as a bearish engulfing or hanging man candlestick pattern) or sharp opening gap down, which signals the short-term bounce is losing steam. Similarly, we always take the same approach on the long side when buying pullbacks of uptrending stocks; we always wait for a pullback to form some sort of reversal pattern before buying (rather than trying to catch the bottom of the pullback).
Below is a chart of O'Reilly Automotive ($ORLY), which is a good example of what frequently happens when attempting to sell short a breakdown below an obvious level of price support. Again, entering a new short position as a stock is breaking down below the low of a range is something we are not very comfortable doing:
A lower risk way of initiating a new short sale, which also provides you with a more positive reward to risk ratio for the trade, is shown on the following chart of Check Point Software ($CHKP). This is an example of what we are looking for when entering a short position (although the declines are not always as dramatic):
On October 17, CHKP gapped down sharply, on huge volume, due to a negative reaction to its quarterly earnings report. This caused the stock to crash through a four-month level of price support at the $44 area (dashed horizontal line). But over the past week, notice that CHKP has been climbing its way back up to test new resistance of its breakdown level. If CHKP now manages to probe above the intraday high of October 17, it would see some short covering, as most traders would not have expected the price action to climb back to that level. Further, the 20-day EMA is also above to lend a little more resistance. It is at that point ($44.50 to $45 area) that we would look for the first bearish reversal candle OR opening gap down to initiate a very low-risk short selling entry with a positive reward-risk ratio. By waiting for a significant bounce into new resistance of the breakdown before selling short, we can "be right or be right out" by keeping a relatively tight protective stop.
In our Wagner Daily swing trading newsletter, the current near-term plan with regard to individual stock and ETF trades is to remain patient and wait for proper, low-risk short setups to emerge. When the stock market eventually and inevitably bounces, we anticipate nice short selling opportunities to develop, and we will be prepared to take advantage of them. As for the long side of the market, we are not even looking for new buy entries right now because the overall stock market has simply deteriorated too much for our liking. At a minimum, even the best stocks and ETFs will now require at least six to eight weeks for new bases of support to develop.
Over the next few days, be on the lookout here on our trading blog for a short video that will demonstrate a quick and easy way to find the top stocks for selling short with the free MTG Stock Screener.