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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 between the way we analyze and buy stocks, compared to short selling stocks. First, it is crucial to realize that trading in the same direction as the dominant broad market trend is the most important element of our swing trading system because approximately 80% of all stocks move in the same direction as the major indices. This is where our objective, rule-based market timing model really shines, as it prevents us from selling short when the main stock market indexes are still trending higher (or going long when the broad market is in a confirmed downtrend). Although it may seem counter-intuitive to new traders, we do not sell short stocks as they are breaking down below obvious levels of technical price support, as they tend to rebound and rip higher after just one to two days of weakness. Rather, 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. Yet, even though we prefer to wait for a bounce before entering a new short position, we also do not enter a new short position while the stock is still bouncing (trying to catch the high of the bounce). Instead, 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 strong stocks; we wait for a pullback to form some sort of reversal pattern before buying (rather than trying to catch the bottom of the pullback). The daily chart of O’Reilly Automotive ($ORLY) below is a good example of what frequently happens when attempting to sell short a stock as it breaks down below an obvious level of price support. Again, entering a new short position while a stock is breaking down below the low of a range is not something we are very comfortable doing: A lower risk way of initiating a new short sale, which also provides traders with a more positive reward to risk ratio for short selling, is shown on the following chart of Check Point Software ($CHKP). This is an example of what we look for 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 week that followed, notice that $CHKP climbed its way back up to test new resistance of its breakdown level. If $CHKP subsequently 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 exponential moving average is also just overhead, which lends a little more resistance. It is at that point ($44.50 to $45 area) that we would look for the first bearish reversal candle OR opening gap down to initiate a very low-risk short selling entry with a positive reward-risk ratio. By waiting for a significant bounce into new resistance of the breakdown before selling short, we can “be right or be right out” by keeping a relatively tight protective stop. Finally, drill it in your head that having the patience to wait for the proper entry points is crucial when short selling stocks, as the short side of the market is less forgiving to ill-timed trade entries than the long side.
One ETF we have been watching closely for potential swing trade entry in recent weeks is PowerShares QQQ Trust ($QQQ), a popular ETF proxy for the tech-heavy Nasdaq 100 Index. Specifically, we have been monitoring a bearish head and shoulders chart pattern that has been developing on the weekly chart interval of $QQQ. If this bearish chart pattern starts following through to the downside, it may create a low-risk entry point for short selling $QQQ (or buying a short ETF such as $PSQ or $QID). In this article, we walk you through the details of this technical trade setup for $QQQ, and present you with the most ideal scenario for actionable trade entry. For starters, check out the annotated weekly chart pattern of $QQQ below: When determining the validity of a head and shoulders pattern, there are a few factors we look for to determine whether or not this bearish pattern is likely to follow through to the downside. One of the biggest technical considerations is the trend of the volume that accompanied the price. The best head and shoulders patterns will be marked by higher volume on the left shoulder and lighter volume on the right shoulder. Such a pattern indicates decreasing buying interest as the pattern progresses. As you can see by the 10-week moving average of volume (the pink line on the volume bars above), volume has indeed been declining during the formation of the right shoulder. Another element we look for is whether the neckline is perfectly horizontal, ascending, or descending. The neckline on the $QQQ chart above is ascending, which means a “higher low” was formed. This ascending neckline slightly decreases the odds of the head and shoulders following through by breaking below the neckline. Nevertheless, between the two technical elements of the volume trend and angle of the neckline, volume is considered a more significant factor in determining whether or not the price is likely to move lower after the right shoulder has formed. Since it’s always best to assess a potential swing trade setup on multiple chart time frames, let’s zoom into the rather interesting, shorter-term daily chart interval of $QQQ: Just as the “line in the sand” for price support of $SPY is last week’s low, the same is true of $QQQ, but even more so. Notice how support of last week’s low in $QQQ neatly converges with both the 50-day moving average (teal line) AND the intermediate-term uptrend line from the November 2012 low (red line). The more technical indicators that converge in one area to form price support, the more substantial and pivotal that support level becomes. As such, be sure to monitor the $67.60 area very closely in the coming days, as a convincing breakdown below that level could be the impetus that sends $QQQ on its way down to testing the neckline of its head and shoulders pattern. Despite the convincing head and shoulders pattern of $QQQ, it is important to keep the following two things in mind: First, due in no small part to recent weakness in heavily-weighted Apple Computer ($AAPL), the Nasdaq has been a laggard throughout the multi-month rally in the broad market. Rather, the blue chip Dow Jones Industrial Average has been leading, and that index still remains very near its multi-year highs. In a fractured market with significant divergence between the major indices, clear follow-through in either direction usually does not come easily. The second (and more important) point is that the head and shoulders pattern, like all technical chart patterns, obviously does NOT work 100% of the time. In fact, far from it. This means that blindly selling short $QQQ (or buying an inversely correlated “short ETF”) at the current price level of $QQQ is risky and not advisable. Instead of entering this swing trade setup based purely on anticipation of the pattern working, our technical trading system mandates that we first wait for price confirmation that indicates momentum has shifted back in favor of the bears. At a minimum, we would NOT enter a short position unless/until $QQQ breaks down below last week’s low, which we now know is a key level of price support. Jumping the gun by trying to get an “early” entry point is never advisable in swing trading. As always, we will give regular subscribers of our ETF and stock technical trading newsletter a heads-up in advance if/when $QQQ gets added to our “official” watchlist for short/inverse ETF swing trade entry.