How To Use Inverted Long Patterns To Find Shorting Setups

If you want to make a long-term living trading stocks on a short-term basis, you must learn how to play both sides of the market. 

In this lesson, I'll show how patterns that I use on the long side work, in reverse, on the short side. If you are new to shorting, you might want to first read my primer lesson on the subject. Before we get into looking at patterns used for shorting, let's review some patterns that I use on the long side. These include pullbacks and variations thereof, cup and handles, Trend Knockouts (TKO)* and Bow Ties.

Here we have a Bow Tie in DenceCree. Notice that the 10-day simple moving average (SMA), the 20-day exponential moving average (EMA) and 30-day EMA go from downtrend proper order (10SMA<20EMA<30EMA) to uptrend proper order (10SMA>20EMA>30EMA) over a period of three-days -- giving the appearance of a "bow tie" (a). The stock then makes a lower low (b) to complete the setup. The following day, an entry is triggered (c) as the stock trades above the high of the setup bar (b). The trend resumes as the stock trades more than 40% higher over the next ten days (d).

Taking a look at TecElan ConSemi, here we have a combination of a pullback-like formation, a Bow Tie and a Trend Knockout. Notice that the stock is in an uptrend (a) by nearly doubling in a little more than two weeks. Also notice that the stock pulls back, forming a two-day pullback (three if you count the reversal from the new highs), a Trend Knockout*, and a Bow Tie (b). The stock trades above the high of the setup bar (b) signaling an entry (c). The trend resumes as the stock explodes for more than 25 points over the next three days (d).

Now let's look at a bigger-picture pattern combined with a setup. ComBroad forms a big-picture cup (a). Notice the wide-range bars higher and a gap higher on the right side of the cup. This suggests extreme strength. The stock pulls back and forms a variation of a pullback I call a Trend Pivot Pullback. This is where a stock in a pullback has a one-day false rally--which forms a pivot point. Notice that when this pivot is taken out, the stock resumes its extreme uptrend as the stock gains nearly 70 points over the next eight days (c).

Now that we have familiarized ourselves with patterns used on the long side, let's look at how these same patterns, in reverse, can be used on the short side. Notice that Creedence Systems (CMOS | Quote | Chart | News | PowerRating) forms a Bow Tie as the moving averages come together and begin to spread out (a) -- going from uptrend proper order (10SMA>20EMA>30EMA) to downtrend proper order (10SMA<20EMA<30EMA) over a period of three days. The setup is complete after the CMOS makes a higher high (b). An entry is triggered (c) as the stock trades below the low of the setup bar (b). The trend resumes as the stock implodes, losing more than 40% of its value over the next ten days (d).

Here's an example of a combination of a pullback-like formation, a Bow Tie and a Trend Knockout. Notice that Elantec Semiconductor (ELNT | Quote | Chart | News | PowerRating) is in a strong downtrend by losing nearly half of its value in just over two weeks (a). Also notice that the stock pulls back forming a two-day pullback (three if you count the reversal from the new lows), a Trend Knockout, and a Bow Tie (b). The stock trades below the low of the setup bar (b) signaling an entry (c). The trend resumes as the stock drops more than 25 points over the next three days (d).

Now let's look at a bigger-picture pattern combined with a setup -- but this time in reverse. Broadcom (BRCM | Quote | Chart | News | PowerRating) forms a big-picture inverted cup (a). Notice the wide-range bars lower and a gap down on the right side of the cup. This suggests extreme weakness. The stock pulls back and forms a variation of a pullback I call a Trend Pivot Pullback. Notice that when this pivot low is taken out (the entry), the stock resumes its extreme downtrend as the stock plunges nearly 70 points over the next eight days (c).

As you can see, patterns that work on the long side also work on the short side. By the way, in case you were wondering, ComBroad, TecElan and DenceCree don't exist, I simply inverted the BroadCom, Elantec and Creedence to demonstrate my point.

References, Resources and Additional Reading

Shorting Stocks: The Art Of Playing Both Sides Of The Market, Dave Landry

Trading Pullbacks, Dave Landry

Trading With The Cup And Handle Pattern, Dave Landry

Bow Ties, Dave Landry

The TradingMarkets Guide To Conquering The Markets, Mark Etzkorn (Ed.)

Dave Landry On Swing Trading, Dave Landry

*Rules For Trend Knockouts (TKO)

For Buys: (Short Sales are reversed)

1. The market must be in a strong uptrend as defined by a computer-based indicator such as ADX >= 30 and +DMI > -DMI or as defined by Trend Qualifiers.

2. The market should make at least a two-bar low. Buy tomorrow or the next day (allow yourself two days to get filled), 1/16 above today's high.

3. Place a protective stop below the low of the knockout bar (2). If this is more than 5% away from your entry, risk no more than 5% of the stock's value.

Source: Dave Landry On Swing Trading, Dave Landry