How to Execute Short Trades Using the Throwback Rally
One of my favorite chart patterns for delivering a successful short swing trade is the throwback rally and subsequent failure.
With the market making new highs, then softening into headline risk from Europe, this is an opportune time to look for this pattern, and to take advantage of it.
Here’s how it sets up: The pattern takes place when a stock (or other asset) is trading in the context of an uptrend. Price rises to a relative new high, creates a peak/top reversal pattern, then falls, diving through nearby price support and preferably the 50-day MA. When it finds support, price rallies quickly—usually on the back of a short-squeeze—and rises up to the lower resistance zone of its top reversal pattern. This move is the “throwback rally.”
If the stock cannot penetrate the line of bears awaiting its arrival in this resistance zone, the rally fails. Then price often reverses to the downside, this time offering a good opportunity to sell short. Since price was firmly rejected by the top reversal pattern, that rebuff adds to the odds of this set-up becoming a successful short trade.
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For this trade, I plot the 50-day MA (green) and the 200-day MA (black) on my daily chart. I rely on the price support-breaks to give me entry signals.
50-day MA When I pinpoint my entry, I prefer the 50-day line to be moving horizontally, or at a down-sloping angle. If the moving average is rising at a 45-degree angle, or higher, I may chose to go elsewhere. From experience, shorting stocks with sharply rising 50-day MAs—even in the event they tumble below that line–have poor follow-through to the downside.
200-day MA Since the throwback rally usually occurs relatively soon after the stock makes a price peak, the 200-day MA is usually located below my entry. Still, I want to know that moving average’s location. I prefer not to enter short trades if price is within 7-8 percent of the 200-day line. That’s too close for comfort and doesn’t give the stock enough room to fall, without landing on the line’s potential support.
On my entry day, I want the broad market to be moving lower. Preferably, the sector or industry group where my stock resides is also weak on the day—the weaker, the better.
For my entry criteria, my stock’s price must fall through its 50-day MA. Then it must penetrate recent price support. Entries can be taken below the low of the high day of the throwback rally, if prior price support gives the stock room to fall. A safer entry is (if) when price collapses through that recent price support. “Scaling in” works well here, as traders can sell short a partial position at the first entry, and then if the trade is working well, add more shares when price breaks nearby support and triggers the second entry.
If desired, a protective stop can be placed just above the entry day’s high, or just above an intraday pivot on the day’s 60-minute chart. A profit target can be established just above prior support (at the next level lower than the current level used for entry).
Figure 1 shows a daily chart of Lender Processing Services, Inc. (LPS). Price moved into an uptrend for most of the year, touched a 52-week high of 30.88, then reversed lower. It fell below early support (solid blue line), and below the 50-day MA.
Figure 1 Lender Processing Services, Inc. (LPS) Daily Chart
RealTick® used with permission
While some traders use that first penetration of the 50-day line as a short entry, I prefer to wait for a throwback rally to occur. The added overhead pressure and subsequent failure heightens the odds of a successful breakdown. In this case, that was the best choice, as LPS found price support just below its 50-day MA and reversed.
LPS rallied, but when it gapped into the overhead resistance established before the pivot high, it quickly reversed. Price slid south in a failed breakout and created a bearish engulfing candle that closed below its 50-day MA. The next day opened and price moved up to the 50-day MA, but couldn’t penetrate it, and promptly moved lower. The bears took charge and the throwback rally was in place.
The first short entry could have been taken just under the prior day’s low (under the low of the throwback rally’s high day). Alternatively, traders could wait for price to break below prior support (blue dotted line) to either add to an initial position, or initiate a new short position.
In this case, LPS fell dramatically from its open on the (second) entry day to a prior support level on the daily chart (solid red line)—and then some—giving short traders a dandy profit to pocket before the closing bell.
The current market environment should soon provide traders with plenty of opportunities to take advantage of throwback rallies and short trades that deliver great profits.
Keep green on your screen!