Today’s Trading Lesson From TradingMarkets

Exchange-traded funds offer a special advantage for the short-seller
— to wit, no pesky uptick rule.

Under a rule established by the
Securities and Exchange Commission, you and I can short shares in a publicly
traded company only after the share price upticks. In other words, we can short
only after the stock makes an upward price movement.

Most short-selling cues occur on
downward price moves below a specific pivot point, like the price low of the
prior session. But you can’t immediately short stocks of publicly traded
companies on such signals. Instead, you must wait for the next uptick. By then,
the stock may have forged lower than your desired entry. Also, the uptick might
be the beginning of a rebound rather than a trifling pullback on the way to
lower lows.

The uptick rule, however, does not
apply to

exchange-traded funds. You can borrow shares of a tradable fund and resell
them with no break in the downward price action that triggered your short sale.
There’s no twiddling your thumbs waiting for the next plus tick. You’re free to
short in the direction of the trade as soon as you choose to act.

With that preamble, I’ll now show you
the base failure, a short-selling pattern
that works well after high-flying securities break down.

Mark Minervini, manager of the
Quantech Fund, a New York-based hedge fund, has used this pattern extensively.
Minervini won the 1997 U.S. Investing Championship with a 155% return trading
his personal account.

He calls the pattern “the Ledge.” The
security initially breaks down after a failed base breakout, then sharply
retraces part of the loss, forming a ledge. From there, the security falls,
creating the shorting opportunity.

Minervini uses the pattern to short
individual stocks as well as exchange-traded funds as they fail from late-stage
bases. But as he notes, the absence of the uptick rule makes money management a
lot less problematic when shorting tradable funds vs. stocks.

“If you’re setting a tight stop, and
you have to short into an uptick,” Minervini says, “you run a greater risk of
getting stopped out, whereas if you can short into the direction of the trade,
you run a much lower risk of getting stopped out.”

A basing pattern, of course, indicates
the odds are improving in a security’s favor. So when a base fails, a
significant reversal may have begun in the security’s fortunes.

“The key with this is to get a
late-stage base that fails and comes off hard,” Minervini notes. “Normally, this
price action will take place below a 50-day moving average that has started to
roll over or has already rolled over. Then it comes back up sharply. The price
snaps back, forming a V on the way back up. It’s the combination or convergence
of all these factors that make it a high probability set up. Don’t try to take
just one factor out of the context of the setup. Putting all those things
together is what makes the trade.”

Look for the “synergistic combination”
of all factors before short-selling off a base failure. If you try to short
anything that breaks below its 50-day and fails after a base breakout, you could
wind up shorting a fund or stock in the midst of a consolidation before it
blasts off.

We’ll look at two examples of
exchange-traded funds that underwent base failures, then headed south. Our
examples are the Telecom HOLDR (TTH)
and the Internet HOLDR (HHH).

The Merrill Lynch
HOLDRs, or Holding Company Depository
Receipts, represent fixed baskets of stocks. They differ from another set
of exchange-traded funds called index shares.
The component stocks of index shares change over time to keep in sync with their
corresponding indexes. Examples include the S&P Depository Receipts (SPY),
which track the S&P 500; the Diamonds (DIA),
which follow the Dow Jones industrial average; and World Equity Benchmark
Shares, which track stock market indexes in different countries. The component
stocks of index shares change over time to keep in sync with their corresponding
indexes.

This lesson will identify specific
price stops where you would sell to cap your loss in the event the shorted fund
rallies against your position. You also can use percentage stops if that
approach suits your personal money-management strategy.

Telecom HOLDR

The Telecom HOLDR (TTH)
went through a base failure, or Ledge, before breaking down in May 2000. Like
many sector-focused exchange-traded funds, the Telecom HOLDR was launched when
its industry was riding high. It began trading on Feb. 1, 2000.

The tradable fund was putting in a
base from March 10 to April 11, then it broke down on April 12, undercutting its
50-day moving average. The stock tried to rally back, stalling just below the
50-day on April 26 and May 1. You’d short on May 2, setting your stop at the May
1 high of 86 1/2. You’d sell on any cross above that level.

Internet
HOLDR

Merrill Lynch’s Internet HOLDR (HHH)
did something similar in March-April 2000. The Internet HOLDR broke out of a
correction-recovery pattern, drove into new high ground, failed, declined below
the 50-day moving, pulled back and stalled beneath the 50-day, then gave up the
ghost.

You could liken the base to a
cup-with-handle pattern, with the breakout coming on March 21. For my tastes,
the handle is much looser than the profile of a proper cup-with-handle
if I were considering the stock as a potential buy.
But that’s the point. When you’re shorting securities, you should view flaws in
the base as favorable developments for your trade.

After the March 21 breakout, the
Internet HOLDR advanced to a new high on March 27, then sold off sharply over
the next six days. Then the tradable basket of Internet stocks bounced back,
peaking at 157 1/2 on April 7 just below its 50-day moving average. You’d short
into the downward move the next day, setting your stop at the April 7 high of
157 1/2.

Part 3 in a series
of three. Also see

Part 1: Identify ETF Turns Using Moving Average Crossovers and

Part 2: How To Use RSI To Trade Index Funds.