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You can divide short-selling patterns into two groups: reversal patterns and continuation patterns. I am going to show you examples of both.
A reversal pattern assists you in spotting a major trend change. The short-seller, of course, is interested in spotting recent leaders right as they top and break apart. In a continuation pattern, the short-seller seeks for evidence that a downtrend will continue or resume, usually after some brief pause.
Head-and-Shoulders Top
The head-and-shoulders top is the best-known of the bearish reversal patterns. Individual stocks may form head-and-shoulders patterns during bull markets, but like any trade, the pattern works best when the general market is moving in the same direction. In other words, you run the best chance of profiting from a short-sale when the market itself is correcting.
In a head-and-shoulders top, an advancing stock rallies to a first peak, then falls back, forming the left shoulder. Next, the stock rallies again, this time forming a higher peak before succumbing a second time. This part forms the head. Then the stock attempts a final rally, which peaks below the high of the head. This rally fails, too, forming the right shoulder.
Chart patterns need a pivot point, a price level which, when pierced, triggers a buy, sell or short-sell signal. In the head-and-shoulders top, the pivot point is found by drawing the neckline, a straight line intersecting the lowest low between (1) left shoulder and the head and (2) the lowest low between the head and the right shoulder.
When the share price breaks below the neckline, you short. Of course, always establish an initial protective stop in any trade, long or short. In the case of short-selling, your stop will be a price above where you shorted the stock. Set the price low enough, so if the stock rallies, your sell rule will require you to buy back the shares and cover your short before your account sustains a harmful loss.
Let's look at an example. Tibco completed head-and-shoulders top after the Nasdaq Composite peaked on March 10, 2000, beginning the subsequent bear market.
After an extended advance, Tibco made an all-time high of 137 15/16 on Feb. 29, then fell to a March 7 low of 104 1/2 before reversing to upside. This first high and low formed the left shoulder.
Then Tibco shares ascended to a March 9 high of 147, then dropped anew to a March 16 low of 101, creating the head. The stock rallied again, peaking at 135 on March 24 before rolling over.
By now, you would have had neckline drawn tangent with the March 7 and 16 lows. Tibco shares broke the neckline on March 30. You would conceivably have shorted the stock at 94 3/8. Share closed the day at 87 1/2, opened slightly higher the next session but soon succumbed.
Once a successful short has produced a profit worth safeguarding, I would switch to a trailing stop. Traders using this technique would have been forced to take a tidy profit on April 4 as the stock bounced off the low of the session, 43 5/16.
Other traders, looking for a longer pull, sometimes anticipate a return move, a rally up to, but not above, the neckline and a subsequent failure to lower lows. So once a stock declined enough, they would lower their stop to the neckline.
In Tibco's case, the stock did initiate a return move, peaking below the neckline at 84 1/2 on April 7 before rolling over. The stock made a low of 32 3/8 on April 17 before stabilizing.
The Lizard
Jeff Cooper, inventor of the Lizard, describes it has a "low-risk, potentially high-reward reversal pattern" in the first of his Hit and Run Trading books. He uses it for day trading as he has found that has little follow-through power.
Here are the rules for the short-selling version of the Lizard. (Inversing the rules, you can trade long off the Lizard.)
1. The stock today must open and close in the bottom quarter of the session's trading range.
2. The stock today must make a 10-day high.
3. Tomorrow sell short if the stock falls 1/8 point below the prior session low.
4. Maximum risk is 1 point. If you're not stopped out, cover your short on the close.
Intel formed a Lizard on May 18, 2000, then broke lower. Before I show the Lizard in detail, let's look at a longer-term view.
As you can see from the above chart, Intel shares were well into a downtrend by May of that year, and of course, the market had corrected sharply as well. So you had both the stock's longer-term trend as well as the market trend working in favor of the short-seller.
So this particular Intel Lizard is a continuation Lizard, one which sets up the short-seller to take advantage of the continuing trend. A short-selling Lizard also can form at tops, which would be an example of a short-term reversal pattern.
Intel shares made a 10-day new high on May 18 (see Point A on the chart), an intraday high of 126 1/2, the stock's highest level in 12 days. The intraday low was 123 1/8. The day's trading range, thus, was 3 3/8 points.
Within that range, the stock opened at 123 7/8 and closed at 123 15/16. So both open and close came in the bottom 25% of the day's trading range.
On May 19 (Point B), the stock dropped 1/8 below the May 18 low of 123 1/8. You would short on the first subsequent uptick. As you can see, the stock pulled higher, making an intraday high of 123 5/8. Not enough to trigger your 1-point stop.
If the stock had climbed high enough to stop you out, don't give up. If the stock fell anew and triggered a fresh short signal, short again. As Cooper says: "If things always moved in a straight line and were pat, we'd all be calling in our trades from the beach."
Pullback Shorts
A pullback amounts to a brief pause in an ongoing trend. Pullbacks can provide profitable entries for buys, when an advancing stock reverses to the downside before resuming the dominant uptrend, and for shorts, when a declining stock reverses to the upside before continuing the downtrend.
TradingMarkets helps you find possible pullback shorts. Check out the TradingMarkets Pullbacks from Lows list, updated after each market close.
A feast time for pullback shorts is when an entire industry gets decimated from climax highs. In such instances, fear is running super high, increasing the odds that upside pullbacks are indeed just pullbacks, not the first steps of a rally.
For example, Biogen formed a classic pullback short in mid March 2000 in the wake of the biotech slaughter which began the month before.
On Feb. 18, Biogen shares peaked at an intraday high of 129, then when into a severe markdown that sharpened from March 6. This produced a short-term oversold position, and the stock pulled back.
On March 17, the stock made a pullback high, then closed poorly, ending the day for a loss, below the open and near the bottom of the trading range, all signals that pullback had expired, and the stock was giving up the ghost.
You'd short if the stock fell the next day below the March 17 low of 87 1/4. As a position trader, I'd set my stop at 90.
Biogen obliged the very next session, beginning a fresh dive that did not end in a meaningful stand until the share price hit the April 4 low of 56 1/2.
Dave Landry, an adroit pullback tactician, focuses purely on price action in pullbacks. For my tastes, I like to see volume confirmations. Adding volume to the Biogen chart, we can see that trading activity nicely complemented the story told in the price action.
Notice how volume came in strong during the sharp decline leading to the pullback, then dropped off fast and progressively during the pullback. Also, look how the weakest volume in the pullback coincided with the pullback high.
If the stock's such a bargain at that price, where are all the buyers?
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