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Short Entry Failure, Or How To Reenter A Short Move If Stopped Out

08/23/11 08:55:23 AM
by Billy Williams

Shorting a stock is not a game for amateurs, and even skilled traders struggle with trading during a bear market, but using this three-step process can put the odds greatly in your favor.

Security:   BAC
Position:   Sell

On Wall Street, it is often remarked that it is easier to become a millionaire during a bear market than a bull market because when the trend reverses from bull to bear, the price drop can be a combination of incredibly frightening at the sheer velocity of the drop while at the same time an enormous sense of excitement at the opportunity of such a shift. The difference in profit potential can be a bit like riding an escalator if you're a bear, a slow and steady ascent, in contrast with jumping out of a high-rise building for a bear, a lighting-quick drop to the bottom.

Jesse Livermore, the Great Bear of Wall Street, was a notorious short-seller who made as much as $100 million in a single day during the Great Crash of 1929.

However, the fact is that tops in the market or stocks are incredibly difficult to time and have a strong characteristic of whipsawing back-and-forth in price action that can cause a long series of false starts before the decline follows through with conviction, making it not just hard to profit but frustrating as the small losses begin to add up. The reason for this is because as the market begins to decline, traders and investors vested in a given security get scared because of the downward move and begin to sell off their holdings, which can cause sharp upward price spikes, resulting in you getting shaken out of a short entry.

FIGURE 1: BAC. On June 14, 2011, BAC pulled back on an upward price spike and setup for a short entry, but two weeks later, on June 29, 2011, price once again spiked upward, which would have hit your stop on the original short entry. However on the following day, June 30, 2011, a reentry was triggered, resulting in a quick 40% potential return in only five weeks.
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Still, despite the challenges, there is a three-step process of making effective short trades in the market that have a higher edge of winning than just trend-following or breakout trading by themselves. They are filtering your trades, price pattern recognition, and a method of reentering a bearish trade if you are shaken out by price spikes that hit your stops. See Figure 1.

First, the 200-day simple moving average (SMA) has been a stalwart indicator for traders and investors because when price is trading above this moving average, the bulls are in control of the trend unless price is trading below it, then the bears are in control of the trend. Depending on which direction price is spotted, trading on this moving average will be the direction that you should be looking for an entry position.

Next, when price breaks through the 200-day to the downside, you want to look for price to trade upward in short bursts and, specifically, when a price bar whose intraday high trades above the previous two price bars and then enter as price resumes its downward move at the bottom of the intraday low of that same price bar. Bearish moves are notably fast and explosive, so be prepared for a strong surge downward as price resumes its bearish trend.

Finally, if price begins to oscillate back-and-forth as characteristic of a bearish move, be prepared for the possibility if price spikes upward and shakes you out of your trade, but at the same time, be prepared to reenter the move if the price pattern occurs shortly after your stop is hit. Bearish setups are infamous for shaking out weaker players, causing them to be demoralized and miss the follow-up move that precedes it as price goes on to make a huge move with a large potential profit that ends up being lost.

In closing, shorting the market is not a game for amateurs and, in fact, even skilled professionals struggle with trading during market declines. However, this three-step process will help you isolate the strongest bear moves with the highest probability of success if you use it in a disciplined approach that controls your risk while capitalizing on your winning trades.

Billy Williams

Billy Williams has been trading the markets for 27 years, specializing in momentum trading with stocks and options.

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