|In a July 2011 article, I detailed how historical seasonal patterns for the summer months usher in a strong degree of weakness that results in a bias in the market ranging anywhere from trading within a price range or experiencing a decline. Now, as August begins, the market has gone from experiencing a lack of follow-through to experiencing a high level of distribution in recent days where the SPX reflects massive selloffs, creating opportunities to short the market.|
Stocks undergo a change of trend and tend to trade below major simple moving averages (SMA) such as the 50-day SMA. The 50-day SMA is an important average to watch because it helps indicate the strength and health of a trend when it reveals a bullish price direction by pointing from the left-hand corner of a stock chart toward the upper right-hand corner of that same chart. See Figure 1.
|FIGURE 1: CMP. CMP set up beautifully for this short as the summer seasonal pattern ushered in weakness, resulting in CMP trading throughout its five-day SMA, pulling back, and then declining sharply for a 12-point gain so far.|
|Graphic provided by: www.freestockcharts.com.|
|However, when price experiences strong selloffs, it can result in a price reversal and, upon trading through the 50-day SMA, shows you that momentum is becoming bearish. |
The opportunity lies as price trades below the 50-day SMA and then pulls back slightly, snapping back as if price were trying to fight the decline before actually giving in. This is important because shorting a stock can be tricky and even the professionals get it wrong at times; once a stock trades through a 50-day SMA, it tends to repeat this phenomenon where after a sharp decline through the 50-day SMA, there is a brief sharp pullback before the real steep bearish decline takes place and this is where the money can be made. After a while, the 50-day SMA will change trajectories and begin pointing downward, confirming the bearish trend in play.
|Compass Minerals (CMP) had been detailed as an example of this strategy just as it was setting up prior to publication. In late May, price had been trading along a 50-day SMA that had flatlined by sitting horizontally across the stock chart before the summer seasonal pattern injected a degree of weakness in the market, resulting in CMP starting to make the move downward.|
On July 7, 2011, CMP pulled back to a significant high whereupon the next day, the price bar closed below the intraday low of the previous trading day and signaled an entry into a short position.
|The stock gapped down hard on July 11, 2011, for an immediate gain, giving you an immediate headstart in profiting from the explosive price decline, which was later followed by CMP's whipsawing price action that is indicative of summer trading. Finally, CMP rolled over, falling like a rock to a low of $75 on August 3, 2011, and is unlikely to recover from this low.|
|The window of opportunity for these types of trades can be small, which is why it's important to take note of when they set up and have a strategy in place when they materialize. If you miss the initial decline after the first snapback, then wait for any pullback that doesn't trade up through the 50-day SMA as a valid trade and consider using put options to help mitigate your risk.|
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