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Traders have long known that many buy-side chart patterns can be inverted to time short entries. For even better results, we've also learned to turn the fundamental picture on its head as well: weak or deteriorating corporate performance for shorts vs. strong or improving fundamentals for longs.
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The medium-term trader who knows how to combine inverted patterns and negative fundamentals to spot short trades can turn a profitable side business in bear markets while the one-sided long traders are confined to the sidelines.
However, shorting off inverted patterns involves more than just applying your technical and fundamental rules in reverse. For one thing, short-selling involves the uptick rule (although there is talk of repealing this restriction). The trader must also take into account the nature of fear. Fear is not the mirror image of greed. Fear tends to produce sharper moves, both to the downside and in short-covering rallies, than greed produces in upside stock moves. So the trader often must contend with greater volatility following short entries than occurs after long entries. As we'll see, this means taking smaller positions and allowing wider price stops when you short than when you go long.
In this report, I am going to teach you how to combine pattern, trend and fundamentals to sell short using one of my favorite patterns: the inverted cup-with-handle. This is a natural short-selling setup for traders who are already familiar with the normal cup-with-handle. The logic behind both patterns is nearly the mirror opposite, making it easy to grasp one if you fully understand the other. But there are important exceptions.
If you're unfamiliar with short-selling, I recommend you first read Dave Landry's report, Shorting Stocks: The Art of Playing Both Sides of The Market. Then this report will make much more sense to you.
You also should have a good grounding in the normal or buy-side cup-with-handle. For examples and interpretation, see my reports The Psychology of Chart Patterns and Using Volume: The Key to Price & Liquidity.
Trend Continuation
This report is meant for the intermediate-term momentum trader who seeks to hold on for advances or declines lasting weeks to months. So let's get one thing clear. The pattern itself can look picture perfect, but a strong prior trend must be in place. There are valid ways to use the pattern as a reversal pattern off a bottom or a top, but that's not the classic way that intermediate-term momentum traders put the pattern to use. We use the cup-with-handle and its kin as continuation patterns to time our entry into stocks that we hope are about to resume a strong prior trend.
Consequently, I go long off a cup-with-handle only if the overall pattern occurs in the context of a strong prior uptrend, a method popularized by the legendary William O'Neil, who developed many of the modern rules for exploiting the cup-with-handle and its shallower cousin, the saucer-with-handle. The hope is that the uptrend will resume following the breakout to the upside.
Similarly, I go short off inverted cup-with-handles only in stocks that have well-established strong prior downtrends. The hope is that the stock will resume its downtrend following the breakout to the downside.
Price trend is so important that I want the relative strength line to share the same direction as the price trend. A rising RS line for longs; a falling RS line for shorts.
My first acquaintance with this inverted pattern came in reading William Jiler's 1962 classic, How Charts Can Help You in the Stock Market, an insightful little classic first published in 1962. However, Jiler largely treated the pattern as a topping or reversal pattern. I pretty much owe my rules to trading the pattern to Mark Boucher, who uses the inverted cup-with-handle as a continuation pattern to time short entries into stocks in well-established downtrends. No two traders trade exactly alike. As I go along, I'll explain some differences in our trading methods. You can choose or modify the approach that fits you best.
Inverted Cup-With-Handle
In the case of the inverted cup- or saucer-with-handle, you are looking for a stock that is in a major downtrend. So, it must have come off significantly from its all-time or 52-week high. Stocks in major downtrends are likely to continue, but just buying stocks making new lows can get you into trouble. At some point, a stock will find its bottom, and by buying just on a new low, you could go short just when powerful value investors and other bottom-feeders are moving in for the kill, producing a rally in the stock. You also could run into a short-covering rally. Even if a stock is ultimately headed lower, short-covering can produce vicious upside reactions that will stop you out of your position.
The inverted cup-with-handle helps to reduce the odds of running into this scenario. J.C. Penney (JCP) traced the pattern in 1999, broke out and fell to lower lows.
The top field of the following charts uses a logarithmic price scale and displays a 50-day price average line in red. In the second field, a blue relative strength line represents the displayed security's price performance relative to the S&P 500. The third field displays vertical daily volume bars with a 50-day moving average line in blue for volume.
A stock is in a major downtrend. At minimum, it should be significantly off its all-time or 52-week high and trading below a downward-sloping 50-day moving price average. All the better if the stock also is trading below a 200-day moving price average. The relative strength is sloping downward, confirming the price downtrend.
At some point, the stock reverses off a new intraday price low (see Point a in the following chart) and stages a reaction to the upside. This probably reflects a blend of buying demand from short covering, as well as long trades by investors betting on a bottom, and briefer-term players. This countertrend move should carry the stock high enough that it crosses above its 50-day moving average. It's fine if the stock crosses above the 200-day as well. Then the stock loses steam, peaks (Point b), starts to give ground and heads back to earth. This move have served to clear out the last big round of short-covering.
You should not look for a proper handle to form until the market price has dropped to the midpoint between the pre-reaction low (Point a) and subsequent peak (Point b). To find this midpoint, simply add the low and peak prices together and divide by two. The lower the price falls down the right side the better, as each price move down increases the evidence that the countertrend rally has been broken and the last influx of buyers are coming under increasing pressure to sell. Handles that form higher in the pattern are premature.
At some point after the stock falls below the midpoint, it stops falling and starts to reverse upward again (Point c). Now the stock puts in a handle, which could be fomented by another around of short covering, as well as a new set of long buyers betting that the stock has found a bottom. Also, short-selling and selling may have dried up as people anticipate the stock is approaching resistance. Whatever the causes, the stock rises, starting the handle. This time the upward move is inferior to the prior a-b reaction. The stock peaks again and falls anew, indicating that this secondary reaction has failed as well.
As the stock drops again, get ready. The low of the handle is the key to your pivotal point. As soon as the stock crosses below that price point (Point d), you sell short, setting your initial price stop just above the high of the handle.
While you can go as short as five weeks, the whole pattern really should take at least seven weeks to form, from beginning (Point a) to breakout (Point d). In the J.C. Penney example, the stock formed its inverted cup-with-handle over seven months. There is no maximum percentage depth of the cup (vertical depth distance from "a" to "b"). This differs from the normal (buy-side) cup-with-handle, where extremely deep bases are faulty and prone to failure.
Now let's take a closer look at the inverted handle in the following chart. As with normal handles, sometimes the inverted handles can get a little wily, sending you an entry signal only to stop you out, but then set right back up and send a second valid signal that works out. That happened here.
As you can see, J.C. Penney's stock falls down the right side of the cup, makes a final low on Sept. 9 (Point 1 in the following chart), then starts to wedge upward, beginning the formation of the handle. The handle peaked on Sept. 17 (Point 2), which forms the basis for your initial price stop. Then the handle returned south and on Sept. 21 (Point 3) broke below the Sept. 9 low. So you got short.
However, the stock wasn't quite ready to give up the ghost. It reacted to the upside. As it exceeded the high of the handle (Point 2) on Sept. 22 and Sept. 23 (Point 4), you would have been stopped out. Despite this stop-out, the handle remained intact with the Sept. 23 session printing a new high for the handle. On Sept. 24 (Point 5), the stock broke below the lows of the handle, this time on more convincing price range and volume expansions. You go short again here, setting your stop a tick just above the high of the handle (Point 4).
Ideally, the downside breakout will occur on a surge in volume, indicating that the break below support has sent shareholders on the run. However, a valid downside breakout also can occur on average volume (as averaged over the past 50 sessions) in a sign that buying has shriveled up relative to selling.
Mark Boucher wants to see his breakouts (for long as well as short trades) occur on a lap, gap or thrust. On a lap-down day, the stock opens below the prior session close and does not fill the space between the session's highest high and the prior day's close. On a gap-down day, the stock opens below the prior session intraday low, and the intraday high overlaps the prior session's intraday low.
On a down-thrust day, the stock moves lower on a significant price-range expansion and closes near the low of the range. Mark wants the range expansion on the breakout day to be at least double the average daily range of the previous 20 days. I'm not that mathematical. If the price-range expansion looks vigorous to the eye, as it does in the J.C. Penney breakout (Point 5), that's good enough for me. I also like to enter my positions as soon as the stock hits my pivotal point (a tick below the low of the handle). So, I probably won't know whether a session produces a thrust or significant volume expansion until after my order is filled.
The following chart of Dillard's (DDS) provides another example of the inverted cup-with-handle. The pattern started on Oct. 27, 1999, formed the handle low on Feb. 17, 2000 (Point a), with the breakout on Feb. 24 (Point b).
Fundamental Screen
I do not apply strict fundamental criteria to gap-down shorts. If the downtrend is strong and confirmed by a downtrending relative strength line, I'll consider shorting the stock regardless of the fundamentals. But it should go without saying that declining earnings or rising losses and high valuation add credibility to a short candidate.
If you want a specific fundamental screen for shorts, I recommend you use Mark Boucher's down-fuel criteria. A short candidate should have either:
Mark also likes his short candidates pricey, leaving ample room for valuation contraction. By his book, a good short candidate should have a price-to-sales ratio greater than 10 and/or a price-to-earnings ratio greater than the P/E on the S&P 500.
Initial Position Management
Many intermediate-term momentum traders used fixed percentage price stops to protect themselves in case a stock turns against them. This is fine when trading the long end. Bill O'Neil has called for initial price stops of 7% to 8% of your cost, which assuming you are finding valid patterns and executing your trades decisively after you pivot is hit, should keep you in plenty of winners while minimizing stop-outs from losers.
However, short-selling is a different matter. Short-covering rallies in downtrending stocks can be quite violent. Even an initial price stop of 15% percent of your cost will bounce you out of too many trades to make a profitable business of shorting the inverted cup-with-handle.
In order to ride out this added volatility, you should set your stop a tick above the high of the inverted handle (Point 4 in the above two chart). Of course, this means that many times you will wind up assuming more risk to stay in a position than would be the case if you used, for example, an 8% stop. So you should reduce position your position to keep the overall exposure of the position to your portfolio constant.
As a general rule, you should risk no more than 1% or 2% of your total portfolio on any single position, long or short. Now don't get confused. When I say not to "risk" more than 1% or 2% on any single position, I don't mean "allocation." I mean the percentage amount you will allow a stock to move against your position before you cover your short or sell your long.
For example, let's say your account equity totals $500,000 and your maximum risk per position is 2% of your total account equity. Your maximum monetary loss per position is $10,000. So imagine that you plan to short shares in XYZ Company. The stock is forming an inverted cup-with-handle. Assume your pivot point is 20 and your initial stop above the high of the inverted handle is 24, representing a theoretical loss of 20% of your original capital committed to that particular trade.
Divide maximum account loss per position ($10,000 in this case) by maximum loss per trade (20% or 0.20), and you get your allocation (position size) for that trade ($50,000). The greater the risk, the smaller the position. The smaller the risk, the greater the position.
For more on this aspect of money management, see my report Adjusting Stops for Volatility.
Profit-Taking
If a shorted stock rallies on you and hits your initial stop above the high of the inverted handle, you cover your short and take the loss. No regrets.
Assuming the stock heads south and becomes a profitable trade, you need a different plan for profit taking. Because of the danger of sharp countertrend reactions throughout the life of a short trade, I recommend that you take half profits as soon as you have a 20% to 25% profit in your trade while letting your remaining position ride. This should get you to breakeven in the event a subsequent short-covering rally stops you out. So in effect, you're using the "house's money" to finance your wager.
You also should move down your protective stop on your remaining position to breakeven as soon as is practical. Here's a good technique for successful trades: You short a stock on a breakout from an inverted cup-with-handle, and the stock falls, creating a profitable position. You take half profits at 20%. The stock falls a bit more, then rallies. Give the rally six days, sufficient time for the stock to digest any short-covering.
At the close of the sixth day, Mark Boucher likes to bring his down to either the high of the countertrend rally or to your breakeven point. From there, once you have a profit that you want to be sure to protect, you can use a mechanical trailing stop.
These are very sound rules. Like Mark, I often take half profits in long as well as short trades, but I am more discretionary in how I handle the remaining position, as opposed to adhering to trailing stops. You choose the approach that best suits your style of trading, but however you take profits, be sure that you take measures to protect the bulk of your original capital. Small losses and stop-outs are an inevitable part of trading. But you should always guard against big losses.
Other Pattern Considerations
In passing, I might note that other traders have found different ways to trade the normal and inverted versions of the cup-with-handle, saucer-with-handle and Japanese fry pan described by Steve Nison in Japanese Candlestick Charting Techniques. Some use it as a topping or bottoming pattern rather than as a continuation pattern.
These approaches, while valid, are not generally recommended if you trade exclusively according to intermediate-term momentum principles. If you are new to trading, I think it's a poor idea to try to trade significantly different styles -- such as short-term and intermediate-term -- at the same time. You are blending conflicting elements of both styles and creating a losing mutation rather than a coherent strategy.
For instance, I'm a big fan of Dave Landry, a savvy short-term and swing trader, but some of his pattern methods don't fit with my intermediate-term approach. Dave uses low cup-with-handles as well as high cup-with handles. Since I am seeking to enter and hold out for profitable moves lasting weeks to months, I rule out low cup-with-handles because of the risk of running into selling from overhead supply over the intermediate term, a factor that poses less of a problem for short-term trades.
With that caveat, you still can gain insights by looking at how other traders exploit these patterns. For more on how Dave's take on the cup-with-handle as well as his take on pattern inversions, check out his reports How To Use Inverted Long Patterns to Find Shorting Setups and Cup-and-Handle Trading Techniques For Swing Traders.
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