How to short the housing market

August 24, 2006
Deron Wagner

Stocks traded higher out of the starting gate
yesterday, but weaker than expected housing data released at 10:00 am EDT
triggered a reversal that led to broad-based losses. Small and mid-cap stocks
sustained the worst losses, as the Russell 2000 slid 1.3% and the S&P Midcap 400
fell 0.9%. The Nasdaq Composite lost 0.7%, while both the S&P 500 and Dow Jones
Industrial Average declined 0.4%. A modest recovery in the final thirty minutes
of trading helped reduce the losses, but the major indices still finished in the
bottom third of their intraday ranges. Per intraday e-mail alert to subscribers,
we bought the ProShares UltraShort MidCap 400 Index
(
MZZ |
Quote |
Chart |
News |
PowerRating), which is
inversely correlated to the S&P Midcap 400 with leverage of 2 to 1. We also sold
short the iShares DJ Real Estate Index
(
IYR |
Quote |
Chart |
News |
PowerRating), and remain short the Russell
2000 Index
(
IWM |
Quote |
Chart |
News |
PowerRating)) from our August 1 entry.

In keeping with the pace of the summer doldrums,
total volume in the Nasdaq declined by 7%, while volume in the NYSE was about
the same as the previous day’s level. Although the stock market closed lower,
the flat to lighter volume prevented the S&P and Nasdaq from registering a
bearish “distribution day.” Volume in both exchanges was also once again below
average levels. In the NYSE, declining volume exceeded advancing volume by a
margin of 2.7 to 1, but the Nasdaq ratio was negative by only 3 to 2.

When in a strong market, breakouts to new highs
are one of the easiest and most profitable plays you can make on the long side
because the lack of overhead supply enables stocks and ETFs to continually set
new highs with ease. But breakouts have a high tendency to fail in weak markets,
as traders often sell into strength of the upward momentum. When breakouts do
fail, it often causes stocks and ETFs to collapse rapidly because the bulls who
bought the breakout become trapped. Selling short these failed breakouts works
well, but proper timing for the entry is critical.

Last week, we discussed a potential trade setup
to sell short the iShares DJ Real Estate Index
(
IYR |
Quote |
Chart |
News |
PowerRating), as it had failed to
hold its breakout to a new all-time high. Because it kept drifting higher after
the initial failure, it never hit our target price and we removed it from our
watchlist. However, it reacted quite negatively to yesterday morning’s existing
home sales report, causing its daily chart pattern to become more bearish than
it was last week. In addition to its failed breakout, IYR now also exhibits a
subsequent “lower high” that corresponds with a “bearish engulfing” candlestick.
The “bearish engulfing” pattern forms when a stock or ETF opens above the
previous day’s high, but finishes below that prior day’s low. It is a negative
pattern that has a tendency to rapidly reverse momentum to the downside. Take an
updated look at IYR:

As you can see, we now have several clear reasons
for being short IYR: failed breakout in a weak market, and the start of a “lower
high” with a “bearish engulfing” candlestick. The other thing we like about
yesterday’s short entry is that we have a clearly defined stop loss over the
prior high of August 4. If IYR rallies above that high by more than a few cents,
the play is no longer valid and we no longer want to be short. However, as long
as it stays below that level, we can stay short and let the trade setup do its
thing.

On some occasions, you may attempt to sell short
a particular stock or ETF and your online broker informs you there are “no
shares available” for borrowing and selling short. Because IYR is not yet a very
well-known ETF, this may occur if you attempt to sell it short. If that does
happen, don’t fret. All you need to do is simply call your broker and ask them
to “locate” shares for borrowing. Our hedge fund has done that on several
occasions with our broker and have always had no problem getting shares to
short. A good broker will also keep a wide inventory of stocks available for
borrowing to begin with. If you already tried calling and your broker still
could not get you shares, you may consider making your own “synthetic ETF” by
simultaneously selling short a basket of the leading stocks in the sector. In
the case of IYR, ticker symbols such as SLG, PLD, and VNO would be ones to
consider. Alternately, you could simply switch to a different broker.

As for the broad market, both the S&P 500 and
Nasdaq Composite closed below their four-day, sideways ranges that we discussed
in the August 23 issue of
The Wagner Daily. That break of support should lead to lower
prices in the near-term, which is why we sold short the S&P Midcap 400 (through
buying MZZ). But just remember that we remain in the summer doldrums and light
volume markets can change direction rapidly. Both our intermediate and
short-term biases are now bearish, with a greater bearish emphasis on the
intermediate-term. As always, proper stop losses are in place in case we are
wrong. Trade what you see, not what you think!

Open ETF positions:

Deron Wagner is the head trader of Morpheus Capital Hedge Fund and founder of
Morpheus Trading Group (morpheustrading.com),
which he launched in 2001. Wagner appears on his best-selling video, Sector
Trading Strategies (Marketplace Books, June 2002), and is co-author of both The
Long-Term Day Trader (Career Press, April 2000) and The After-Hours Trader
(McGraw Hill, August 2000). Past television appearances include CNBC, ABC, and
Yahoo! FinanceVision. He is also a frequent guest speaker at various trading and
financial conferences around the world. For a free trial to the full version of
The Wagner Daily or to learn about Deron’s other services, visit
morpheustrading.com or send an e-mail
to deron@morpheustrading.com.

How to short the housing market

BUY THE FEAR, SELL THE GREED

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