Essential Steps for Shorting SPY and The Stock Market

Shorting the stock market is never easy.  However, the market often gives us clues that increase the probability of a successful trade.  Two weeks ago we talked about those clues.

How to identify a market short signal

Since then the market made an attempt at remounting the 50 day moving average.  If SPY had held those levels, the short setup would have been invalidated and we would be back to holding a bullish bias.  I did not let go of my short since the market is showing underlying weakness and the remount was far from explosive.

Today we got the failure of that remount with a huge down move.  Over in the Trade Report we are still holding our short position with our target at the 200 day moving average.

This two minute video goes over the SPY short trade.



http://youtu.be/qYlwLMiVqHQ

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3 Bounce Entries For SPY

While SPY is oversold, I would like to see more weakness before entering long based on oversold conditions. The chart below shows three great bounce entries:

The SPY Failed Breakout Trade

On August 12th I went short SPY around $131 (actually used SDS) based on the "failed breakout scenario" I noted in the trade report. While it's been a bumpy ride, the trade is really starting to take off now. This is a good example of how important it is not to pull out of a trade before a support/resistance based stop is hit.

See this post for some detailed analysis of the trade. I highly recommend reviewing this post.

Unfortunately I don't have annotation capabilities from where I am writing this, but take a look at the longer term weekly chart of SPY. As I pointed out back in August, the long term trend for SPY was and is still down, and the bounce was forming a nice looking bearish flag. This is one of the things I took into account when making the early "failed breakout" trade.



Now let's look at the current daily chart. This is what I call a beautiful breakdown (assuming it closes like this) of a trading range support level that we have been watching closely in the trade report over the past month. Those of you not yet in the short trade trade can wait for a pullback toward the top of the breadown bar and 50 day moving average for entry.



I have been quite aggressive with this short setup, so I used SDS rather than shorting SPY. SDS provides 2x the leverage.

SPY Trade Analysis

Last Monday (August 12th) I took a small SPY short position based on a "failed breakout" scenario, above $131 (I actually used SDS--the inverse ETF). It's now trading at $126.69. Below is what I wrote to my trade report members. It explains not only the setup, but the thought process and trade management strategy that went into the trade:

Price action in the SPY crossed a major hurdle by closing above the 50 day moving average today. The key now is to see if this level will hold. I still expect a pullback, and actually went short today at the close. Very small position. There is absolutely no setup that I trade that told me to go short today. I can't remember the last time I took a short position when a stock crossed above the 50 day moving average. This trade was based on a hunch and some "risk strategy".. I have a feeling that the market will not be able to sustain this upmove without a pullback.

Many of you are probably thinking this is a dumb trade. I won't argue with you, but let me explain my reasoning using poker.

This weekend I was at a table with 5 other players. All five players had called a $12 bet, and I was the "big blind". If you don't play poker, don't worry about what that means. All you need to know is I needed to put $6 into a pot that was had already built up to $60. Thus, my pot odds were 10:1.

I did not have a great hand. I was holding pocket 9s (two nines). Considering everybody was playing, at least a few players were likely holding a card higher than 9, and the upcoming community cards would likely have at least one card higher than nine, there was a good chance I would lose the hand. However, there was an eight percent chance that one of the community cards would be a 9. That would give me a set, which is a strong hand that I would likely win. Chances are also good that if a 9 did come on the flop, I could sucker at least one or two players with a higher two pair into betting more money that they would inevitably lose.

Let's say whenever a 9 comes I can figure on winning an average pot of $120. Using the 8 percent chance, I will win $960 every 8 out of 100 times this happens. I will lose a total of $552 total in the other 92 hands for a total gain of $408 over 100 hands with pocket 9s. I know some of the poker buffs will argue with my $120 figure--I'm going by my own experience and ability to read opponents and disguise my own hand.

An aside for the poker fans: What actually happened was a miracle . . .a 9 did come down on the flop, and so did an king (and no flush or straight draws). The guy with the king went all in, $230 and I called. I ended up winning a $300+ pot (excluding my own contributions), based off an initial risk of $6 that allowed me to see the flop.

Now can you see where I'm going with the SPY short trade? There is a good chance I will lose with the trade. I know this going in. Based on my stop placement and position size (200 shares) I am risking very little just to see what happens. I have placed my stop around $132 (I am actually using SDS to short, so $132 and 200 shares are is not exact figures).

Now if we get a failed breakout (SPY breaks back down below the 50 day MA), I think there is a good chance of a retest of lows ($120-122). Let's say I place my target above that at $122. I have risked $230 with the chance to "win" almost $2000. I can get stopped out 9 out of 10 times, as long as one of the trades reaches my target, and still break even.

See the logic? There is a method to my madness. I'll take looking bad for a trade or two (or 8), as long as in the long run it makes me money.



There were a few days that I thought about getting out of the trade (when SPY remounted the 50 day ma), but decided to stick with my original analysis and stop. Spy has now convincingly broke down below the short term trendline and 50 day ma.



This might mark another decent entry point, as I would not be surprised to see more downside near term. Here is what I wrote about SPY in last night's trade report:

The early "failed breakout" short play in SPY that I took on last week is still in play. Price closed just below the 50 day ma, but not enough to get really excited. If SPY closes tomorrow below the trendline in the chart below, I expect we'll see lower prices.

If not already in the SPY short trade, I still feel there are only two places to enter short. Either on a break below the trendline and 50 day ma, or a rise to the 200 day ma (see yesterday's report)



Finally, here is the SPY discussion from Monday's report, which setup the short scenario in more detail:

I noted early last week that the SPY presented a low risk short play. Remember that low risk does not mean high probability. Risk is only a measure of what you could lose versus what you can gain. I also laid out how I take on many low risk trades, lose out on some with small losses, but will have a few big gains that more than make up for the losses.

While SPY the low risk short has not officially turned into a loss yet, it has mounted the 50 day and Friday held up above that support level. The stop is above the recent high of $132, so the possibility of the failed breakout trade working out still exists, but there is not doubt the bottoming pattern is still in play. While I will stay with this trade until the stop is hit, I would not recommend initiating another SPY short just yet.

However, I am not likely to go long either. Volume on this upswinging bottom play is not the type that propels price dynamically higher. This could be a result of options week, but still, I don't like entering longs if volume does not confirm price.

If you are looking at an opportune time to short SPY again, there are two low risk entries.

1) If price again breaks down below the 50 day ma. The low volume makes this a decent possibility.

2) On a low volume rise to the 200 day ma, in the 135-137 range. This presents a great short on two different time frames. We already know the daily like the back of our hands, so let's flip down to the weekly chart.

Daily



Weekly:
The first thing that jumps out is the head and shoulders top formation. During the top formation, RSI has down trended and volume has shown a great amount of distribution (selling). Now, price is pulling back up towards the neckline of the head and shoulders formation, which should act as support. This is a good, low risk area to place a short trade. Add to that that this level is also right around where the downtrending 50 week ma is hoverning (138), and is also the same area where the daily 200 day ma is located (136)--well, talk about a great short setup.



It will take time and patience for this trade to setup, but keep on the lookout. In the meantime, watch for a breakdown of the daily 50 ma, and focus on trading setups.

No new sectors that we have not already discussed jumped out at me, so I'm going to go straight to the watchlist. Lots of stocks setting up. This week we have over 60 that we will focus on.

Whew . . .it's been an exciting trade with many ups and downs. This is a good example of how important it is to stick with your trade until your stop or target is hit.

SPY Breaches Key Support Level

As I noted in the member only Trade Report two days ago, I took an early entry short position in SPY (via short ETF SDS)based on the idea that a failed breakout could lead to big gains, while continued up move would stop me out for only a small loss.

Today we got the breach of the 50 day moving average (as of 11:45 ET). The next key level is the long breakout bar posted 4 days ago. If that support level does not hold, I would not be surprised to see a retest of the recent lows, in the $120-122 range.

Market Notes and SPY

Talk about a brutal day. After all the talk of a market comeback yesterday, I was expecting weakness today, but nothing like this. In fact, I was so confident that the morning dip would be the low point, I bought CROX and covered my MS short (I'll post the trades later tonight). Ouch!

Just as talk of a roaring market comeback was premature earlier this week, it's too early to go into full bear-mode. Take a look at this chart of SPY (S&P 500 ETF). While price made a high percentage move to the downside, SPY is still holding the 200 day moving average that it crossed over earlier this week. If you take the "cup half full" approach, that's a good sign. A break of the moving average would have been an obvious short signal.

Volume is a bit more complicated. A bull can say volume is lighter than last week's slide, so all is good. A bear can say volume is heavier than this week's upmove, and he too would be correct. It's a tough call that I am not prepared to make, so I'm going to focus on price action until volume settles itself.

The main point to take away from the chart is we dont' yet know if today was the end of the market bounce. Until we get a break of the 200 day moving average, I would not make any big bearish *market* bets (there are some individual stocks and sectors that are ripe for shorts).