ETF Trading Tactics, Part 3: How To Short ETF Breakout Failures

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 | Quote | Chart | News | PowerRating) and the Internet HOLDR (HHH | Quote | Chart | News | PowerRating).

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 | Quote | Chart | News | PowerRating), which track the S&P 500; the Diamonds (DIA | Quote | Chart | News | PowerRating), 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 | Quote | Chart | News | PowerRating) 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 | Quote | Chart | News | PowerRating) 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.

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