Battle Plan Trade of the Week: Selling Strength in the SPY
When trading stocks and ETFs to the long side, we always look to buy weakness and sell strength. For short term stock and ETF traders, we have found that there is a strong, consistent edge in buying stocks and ETFs after they have pulled back, and selling them as demand returns.
The corollary to this strategy comes into play when traders are looking to bet that a given stock or ETF is likely to fall. In this instance, rather than buying weakness and sell strength, we look to sell short strength and cover – or buy back – on weakness.
As you might imagine, this approach has been a winning one for the past several months as the continued bear market in stocks and ETFs has provided us with an almost regular flow of opportunities to sell short overbought markets and cover those positions as sellers return to drive those stocks and ETFs lower again.
We took this approach when looking at the overbought market for the S&P 500 SPDRS, SPY
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PowerRating) late in December 2008 and into the first few trading days of 2009.
Increasingly overbought conditions in the SPY – based on extremely high, 2-period RSI values – encouraged us to start building a short position in the ETF over a period of several days between December 31 and January 6.
One strategy that we have used in the Battle Plan was to sell short additional shares of SPY as the ETF closed higher. There are a number of variations to this approach. But we stuck to a fairly straightforward method of adding an additional unit short as the ETF became increasingly overbought to a maximum of three units.
The break in the SPY came suddenly on January 7th as the ETF gapped down to just below its 5-day moving average. The SPY finished the day lower still, closing below its 5-day moving average and showing us the requisite renewed selling that let us know it was time to cover our short positions, “buying” into the weakness.
The first unit we sold short actually lost about 40 cents per share. However, the second unit was covered with a gain of nearly $2.30 per share and the third unit nearly $3 per share.
Selling overbought ETFs short has been a mainstay of our trading in the Battle Plan as the bear market has intensified. And as long as the major markets remain below their respective 200-day moving averages, we will continue with what we believe has been one of the most winning, consistent approaches to short term trading this almost-unprecedented market decline.
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David Penn is Editor in Chief at TradingMarkets.com.