How To Profit From Short Selling Former Leadership Stocks
Feb 04, 2014
On January 30, I said the stock market was about to trigger a new “sell” signal, and also suggested the NASDAQ may fall to the 4,000 level in the near-term.
Three trading days later, the NASDAQ plunged 2.6% and indeed kissed its next key area of support near the 4,000 level (closed the day at 3,997).
That February 3 decline put a nail in the coffin for the current rally, thereby forcing my rule-based market timing model into “sell” mode for the first time since June of 2013.
In “sell” mode, I avoid establishing new long positions because all major indices are trading well below support of their respective 50-day moving averages.
Most have also sliced through support of their prior lows, meaning an intermediate-term uptrend is no longer in place.
Time To Sell Short…But Not So Fast!
With the timing model now sitting in “sell” mode, entering new swing trades on the short side of the market becomes a possibility for me and our subscribers for the first time in 8 months.
However, since most stocks are already too extended to the downside in the near-term, it is crucial to wait for a decent bounce before initiating new short positions (be sure to review this classic blog post for the key points of my short selling strategy).
Trading on the short side requires much more skill in the market timing department, as both sell-offs and counter-trend rallies are substantially more violent on the short side.
This means most of my short entries have significantly shorter-term holding periods than long entries. For example, it may take a market nearly a year to rally 20%, but only one or two months to give back 75% of that advance.
Above all, you absolutely must have a high degree of patience to wait for proper short selling entry points (this timeless video from 2012 explains why).
Short Selling Strategy #1 – Former Leading Stocks
Just as there is very specific criteria for stocks I buy, I am also very detailed in what I look for when short selling stocks.
There are two basic technical setups for swing trading on the short side, each with very different looks in terms of where these stocks are trading in relation to their 52-week highs.
The first setup, and the one I personally favor the most, is selling short a former leading stock.
These former leaders are stocks that have rallied 300% to 1,000% (or more) during the length of the last bull market, and are now over-owned by institutions.
They are usually just beginning to breakdown from an all-time high, and are 20% to 30% below their 52-week highs by the time they hit my radar screen as a potential short candidate (it is way to dangerous to try to call the exact top of a leading stock).
The idea is that once these stocks begin cracking below key support levels, institutions have no choice but to start unloading shares, thereby adding to the bearish momentum and making for some violent moves to the downside.
Lululemon – 3,000% Gain In 4 Years
After a monster, four-year rally that drove the price of Lululemon ($LULU) from $3 to more than $80 (nearly 3,000%), the former leadership stock is now breaking down below a major area of price support:
The monthly chart above shows the huge advance from 2009-2012, followed by stalling action in 2013.
Last week’s breakdown below key support of that prior base of consolidation is definitely a bearish sign, which should soon lead to a test of the $40-$42 area.
From there, $LULU may form a bearish base at the lows OR bounce into resistance of the declining 10-week moving average (similar to the 50-day moving average).
The pink, horizontal line on the weekly chart below shows the area of resistance that $LULU may bounce to, which may present you with a low-risk entry point for swing trading on the short side:
As always, I prefer to react to price action, rather than predict it.
Therefore, I have no idea whether or not $LULU will neatly bounce off support and into resistance of the $55 area.
But if it does, I will be ready to present my exact entry, stop, and target prices for this short selling setup to Wagner Daily newsletter subscribers.
More importantly, even if $LULU does not play out as expected, you now know a simple, low-risk strategy for short selling former leading stocks by patiently waiting for a breakdown to key support, then selling short on the subsequent bounce into resistance.
Out Of Harm’s Way
Prior to the new “sell” signal being generated, my timing model was already in “neutral” mode since the close of January 24.
As such, over the past 10 days, I have only bought one individual stock (with minimal share size) and one ETF.
Further, the great thing about the ETF I bought is that it has no correlation to stock market direction because it follows the price of natural gas ($UNG). Presently, the $UNG trade is already trading approx. 10% higher since my January 30 buy entry in my swing trade newsletter.
I have also already closed most of the winning positions in the ETF and stock portfolios of the newsletter by tightening stops to protect profits.
Laying low since the “neutral” signal was generated on January 24 fortunately enabled our subscribing traders to stay out of harm’s way ahead of the February 3 sell-off (but undoubtedly hurt those who ignored the 3 reliable warning signals of a pending market correction).
To Be Continued…
As previously mentioned, this is just one of the two types of setups I target when short selling stocks. I will cover the second type of short setup (short selling stocks near their 52-week lows) in a future blog post, so stop back again soon.
By the way, if you are not familiar with short selling, you can find a good basic primer here. Furthermore, there’s nothing wrong with waiting on the sidelines, protecting your profits in cash, until the stock market eventually generates a fresh buy signal.
To learn how to profit in both up AND down markets, get started today with your risk-free test drive of The Wagner Daily.