Today’s Trading Lesson From TradingMarkets

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:

• A decline in annual earnings and an estimate of either an annual loss or
  another decline in annual earnings, plus two quarters of declining earnings or
  of negative quarterly earnings;
• or two quarterly earnings down 40% or more, or two negative quarterly
  earnings with an acceleration in the decline.

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.