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Trading StrategiesShort selling stocks

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“This education material does not constitute financial product advice and has been prepared

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Markets Pty Ltd trading as FP Markets (ABN 16 112 600 281, AFS Licence No. 286354).

This document has used the following sources for references:

http://www.zerohedge.com/ and http://www.dfat.gov.au. The charts used are proprietary,

and have been created based of the author’s discretion.


Trading StrategiesA Retrospective Glance:

My recent “Inflection Point” report in March received great interest. It

proved to be rather timely given the recent sell off we have seen across

Global markets. Indeed, the XJO made a high of 5163 on 3/12/2013 and

has fallen -5.4% to a current low of 4883. However, it is the Resources

sector that has really suffered with BHP dropping from $39 to $30.50

in two months. That is almost a -25% decrease whilst RIO has slumped

almost -30% in the same space of time!

RIO Target – shown in the Inflection Point

RIO Target: Now


It seems the Resources sector has come a long way from the bullish sentiment that was encapsulated so succinctly in this tweet from a market “professional”:

“Fear has lost!”20/02/2013 @cliffordbennett

The analysis presented at FP Markets has continuously been on the front

foot whilst this scenario has played out, providing clients with timely

and actionable trade ideas. The reality is that “shorting” stocks is a

very difficult strategy and requires a very different mindset to more

conventional buy techniques.

One question that I am continuously asked is; “What is your favorite

trading strategy?” and “how do you approach the markets?”. No doubt

these are key questions. In this whitepaper, I wanted to expand upon

Trading Strategies with a particular focus on shorting stocks.

Developing a Method:

If I could stress one point it would be that there is no correct or right

way to approach the markets. It took me countless hours of study,

application and real life trading hours before I came to a realization

of what works for me. They say that experience counts for everything

and I couldn’t agree more. I have almost 10 years of screen time and no

doubt have made many mistakes along the way, which have all served

as a learning lesson. The most important thing is to develop a trading

plan that fits your own personality and your own beliefs based on real

observation and study of the markets.

Books such as the “Market Wizards” series by Jack Schwager are

particularly enlightening in this regard. The traders interviewed in

these books show a diversity of styles and techniques whether it is

fundamental or technical, short or long term. However, common themes

always emerge such as the importance of having a trading plan and a

quantifiable edge, as well as the adherence to strict risk management

principles. Too often I see traders without a concrete trading plan and

strategy, and this is their undoing.


Developing Strategies:

To me, stocks and the broader market really consists of a few states:

• A sideways consolidation pattern

• A major trend higher or lower, or

• A runaway/climatic price move to major tops and bottoms.

It really is that simple. Thus, I develop strategies around these scenarios,

of which shorting no doubt plays an integral part. Technical analysis

and studying price action are the tools I use to time such trades.

Here is a brief outline of the strategies I use and present in my analysis:

i) Breakouts: trading breakouts and breakdowns from consolidation

patterns. Using confirmation rules can enhance their effectiveness.

ii) Retracement Trades: buying pullbacks into a strong uptrend; or

shorting rallies into a confirmed strong downtrend.

iii) Climax Patterns: exploiting runaway and climatic trends through

patterns e.g. double tops/bottoms, ending wedges and candlestick

reversal patterns.

AND

iv) “Failed patterns”: these trades try to take advantage of the herd

and fade classic chart patterns once it is clear they have failed.

I wrote about these setups in a separate blog post here: http://

fpmarkets.blogspot.com.au/2012/08/the-most-important-rule-

in-chart.html These are often some of the most powerful technical

setups out there.

i


Below are some real life examples that were all revealed in the FP

Markets Research section. It is all there in print. These examples clearly

illustrate the setup behind each trade and show you what we can offer at

FP markets to put you on the front foot to enable you to “move first”.

Guidelines For Shorting:

• Focus on shorting the weakest stocks AFTER they have reversed and

made their highs. These are the ideal candidates. A stock that cannot

hold up and breaks supports despite a broader strong market is a sign

of genuine weakness. Focus on weak stocks going lower NOT stocks that

are trending higher*.

• Analyze the broader market trend and individual sectors. The best short

candidates are in the underperforming and downtrending sectors.

• Execution and entry is very important. In downtrends, stocks undergo

very sharp bounces and short squeezes. The temptation is to short

when all hell has broken loose but the actual open risk on such

positions increases dramatically.

• Stocks often go down a lot quicker than they go up! Short traders need

to be opportunistic and prepared for quick sharp thrusts lower. Use the

panic to cover positions. You have to be willing to buy and cover short

positions when no one else wants it.

Shorting Examples:

i) Breakdown Trades

Ideal candidates are those stocks in established downtrends with

a series of lower highs in place on the Daily chart.

The key to this trade setup is waiting for a period of consolidation

and potential bounce attempts. It is only a series of failed bounces

that the market is tipping its hand that buyers are losing control.

This is the time to capitalise as a break of support often leads to

sell stops going off and a sharp move lower in the direction of the

bigger picture downtrend once more.

*The exception here are blow off type moves and climatic exhaustion trades. Please see “Climax Patterns” later on.


Copper Daily:

This was the Copper setup shown on the March 1st ASX report. Copper

looked primed for a breakdown given the series of lower highs,

weakening overlapping bounces, and the fact that the commodity was

failing to push higher despite strong equity markets- a lead indicator

Copper Daily: Now

This is how it played out. Traders could have used a number of

breakdown candles as a signal to short. The focus here is shorting a

weak market in a downtrend after a confirmed breakdown.


OZL Daily:

OZL is in a clear downtrend with a number of lower highs and all

moving averages pointing lower. Price was consolidating at the $6

support zone but note that each bounce attempt failed to produce a

meaningful reversal higher.

OZL Daily: Now

The breakdown through $6.00 led to a number of potential short

triggers into the 4.50 Weekly target zone. Once again, the focus is on

shorting weak stocks in downtrends as they lose support.


ASL Daily:

ASL formed a multi month consolidation pattern from 2.80 to 3.20.

However, each bounce attempt slowly became weaker and weaker

forming this topping pattern. The breakdown through supports was the

trigger for a fresh downtrend once more.

ASL Daily: Now


ERA Daily:

A series of lower highs on the Daily chart confirmed the broader

downtrend. A mutli month consolidation pattern failed to produce a

meaningful bounce and a move below supports was the trigger for a

resumption of the bigger picture downtrend.

ERA Daily: Now


Note that in almost all of these examples, one is not picking tops but

focusing on the stocks that are already in downtrends with a number of

lower highs on the Daily chart. After a period of consolidation, traders

capitalise on the breakdown through supports and a resumption of the

downtrend once more.

ii) Retracement Trades

This setup looks to capitalise on bounces back into established

downtrends for low risk short entries. When prices are making new

lows, always look to short the first pullback. Once in the trade, look

for a continuation of the previous trend. One of two outcomes

typically follow – the retest will either fail at the previous low, in

which case a small profit can be made. In the second scenario, a

whole new continuation leg begins.

The key to this setup is obviously deciding when the “bounce”

has gone high enough to initiate the short.

I look for

• Retest of previous support

• Retest of moving averages


NCM Daily:

NCM broke down sharply though key support at 21.00. The stock is in

a clear downtrend. Thus, the most probable trade is to short the first

retracement.

NCM Daily: Now

NCM retested 20.00 in a flag type pattern. There was then a very sharp

reversal as Gold collapsed. This opened up a target into the previous

low and beyond into the weekly target zone (16.50)


RSG Daily:

Breakdown through 1.20 and thus looking to short the first pullback

into resistance.

RSG Daily: Now


iii) Climax Patterns:

These trades look to take advantage of runaway price moves and

exhaustive trends. Note that these are opportunistic type trades

and counter the previous 2 strategies which look to exploit the

weakest stocks.

Key to these setups is waiting for a clear confirmation and a

rejection of higher prices. Examples would be candlestick reversals

out of overhead resistance zones. A tight stop loss point needs to be

identified based off the recent high AFTER the turn.

FMG Daily: 3 Peak Pattern

Back to back bearish reversal candles right into overhead resistance

after a major run up.

FMG Daily: Now


FGE Daily: Ending Wedge Pattern

FGE formed a climatic wedge right into the top end of the range and

overhead resistance area. This offered a low risk short setup with

tight stops.

FGE Daily: Now


iv) “Failed patterns”:

These trades try to take advantage of popular chart patterns and

fade the crowd once it is clear such patterns have failed. Technical

analysis has become very commonplace these days and as such

many traders are looking at the same patterns. If everyone is

positioned the same way and the stock fails to move in the

direction of setup, a swift unwind can ensue which exacerbates

the move in the opposite direction.

With this strategy, one is trying to think about how traders are

positioned and the psychology of the market. What would I be

feeling if I was long the S&P500, thinking I had this great trade,

and seeing the market go against me?

Furthermore, a market that is poised to go higher but fails to do

so is a sign of inherent weakness.


XJO 60mins

The market looks poised for a breakout given the back to back

consolidation and triangle patterns.

XJO 60mins: Now

However, the breakout was sold into and a sharp sell off ensued.

Traders who had bought the breakout were forced to sell out and take

stops, and this further intensified the move lower. The trade to get short

is taken when price moves back below the previous breakout zone.

A market that is poised to go higher but fails to do so is a sign of

inherent weakness.


Trades that didn’t work:

No doubt there are many setups that have not been so successful. That

is the reality of trading and successful traders have to be prepared to

take stops and move on. The key to longevity in this game really is about

cutting the underperforming trades and riding the winners. Sounds so

simple but often hard to do.

STO Daily:

STO broke down sharply through the key 12.00 support zone after a

failed rallied attempt which formed a lower high. This breakdown candle

implied a potential move all the way back down to the lows once more.

STO Daily:

However, there was no follow through and the stock regained the

previous breakdown zone stopping out the trade.


Regular readers of my Research also note that I was looking for

potential topping patterns at times in the Banks. For instance when

CBA was retesting its 2007 GFC highs I was looking for a potential

double top trade out of $62 in January. The stock went as high as $63.70

before reversing lower and the sell off only lasted a whole 3 days before

rebounding strongly in an uptrend!

The WBC double top trade in March out of the $31.50/32.00 level did

work better for short term traders but even this was short lived. The

stock fell to a low of $29.50 from where it rebounded strongly and

subsequently broke out higher.

All one can do is take the stop and look for the next trade. The simple

fact that both these setups failed to follow through to the downside

implied genuine strength and offered subsequent breakout trades

higher in time. This is a complete reversal of the initial short idea! You

just have to be flexible as a trader and heed the price action. It is not

about making predictions, but about being flexible and making money.

Planning Trades:

Most of what I have presented here are just discretionary setups. A

trading plan needs a number of inputs such as the setup, an entry

trigger, stop loss management, and some guidelines on how to manage

the trade. There is not enough space in this document to expand upon

these points in full. I will say that risk and position management is

almost as important as the trade setup itself!

Savvy readers will note that most of the short setups I have shown here have hit their target zones. One will also note that the majority are in the Resources sector and Mining Services sectors as this is the segment in the market that is clearly downtrending. The fact target zones have been hit may imply that a bounce or turnaround in the market is due. Ironically, the simple fact that I am writing this

whitepaper AFTER the event implies the correction may well be done.


Risk Management:

I could write a book about trade management and the importance of

using stops. A stop should reflect where a trade idea is clearly wrong. It

could be manual or automated. The reason for stopping out of a trade

should be when price action is doing something completely counter to

your trade idea. Traders need to understand that they are going to be

wrong a lot of the times. That is the nature of the game in a risk taking

business. However, knowing you are wrong and remaining wrong is the

true mistake.

The trading strategies shown here are designed around low risk/high

reward opportunities. Indentifying such scenarios for traders is key

rather than trying to make long-term forecasts. It is clear in these

examples where the trade idea has been invalidated and that is exactly

the place where stops need to be placed.


ConclusionThe strategies presented here are a brief outline of the short setups

used in my analysis. They are discretionary in nature and are not

an automated system. This is just what works for me through my

experience in the market. I do believe having an approach on the

short side is a valuable tool in a trader’s arsenal. This enables one

to capitalise on both sides of the market. As can be seen in these

examples, it can be very rewarding indeed!

It is also important to stress that shorting requires quite a different

mindset. Downtrends are characterised by sharp rallies and vicious

short squeezes. Identify low risk opportunities and be willing to cover

open positions on extreme panic.

The higher probability trades are focusing on the weakest stocks in

the market in clear downtrends. Waiting for failed rally attempts and

the subsequent breakdown through supports are the ideal pattern.

The higher risk trades are exploiting blow off moves through climatic

patterns but these are for shorter term traders and need very strict

risk management.

Trading is all about trying to identify low risk high reward

opportunities. That is exactly what these patterns and setups attempt

to do. The best we can do as traders is draw upon demonstrable edges,

wait for price action to confirm, and pull the trigger. The trade then all

becomes about position management and knowing when you are right,

and when you are wrong.

I hope this has been enlightening. For those wanting to expand upon

my ides and analysis, follow me at the FP Markets Research section:

https://fpmarkets.com.au/research/register

Thanks,

Austin

Level 5, Exchange House 10 Bridge Street

Sydney NSW 2000

T 1300 376 233 F +61 2 8252 6899

fpmarkets.com.au

AFSL 286354 ABN. 16 112 600 281

Should you have any questions or enquiries, please don't hesitate to contact FP Markets.

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