Four Ways to Short

Targeted short sales should work very well between now and year-end, even if the major indices recover and head back toward their yearly highs. The bull psychology has been damaged just enough in the last month to ensure the steady flow of selling pressure needed to profit from this time-tested strategy.

Sadly, the majority of traders don't even know what a good short sale looks like. Their most common blunder is to enter ill-timed short positions on the strongest stocks, assuming that gravity will take over and knock them back to earth. In reality, major uptrends can persist far longer than rational expectations.

Effective short sales require three elements: the right strategy, perfect timing and extreme patience. If you can't meet all of these requirements, it's best to forgo the activity and limit your trading to the long side. Indeed, short-covering rallies will focus their pain on absented-minded players who haven't perfected these interconnected components.

I keep four short-sale strategies ready to go at all times, depending on broad market strength or weakness. In a nutshell, these targeted plays focus on rollovers from highs, pullbacks to resistance, narrow range at resistance and momentum-shorting. Let's look at a current trade setup for each of these selling methodologies.

1. Rollovers (2B Reversals): The 2B Reversal short pattern sets up when a stock at a new high fails a breakout by dropping under the last swing pivot. The failure usually takes place within one to three bars after the breakout, but can occur weeks later. The sell signal triggers when price trades below the low of the first recovery bounce.

Synchronoss Technologies (SNCR - commentary - Cramer's Take) shows a developing 2B Reversal short sale. The stock printed a new high in late July and then sold off with the broad market. It returned to resistance one month later and broke out on Sept. 18. Price then hovered sideways for over a month before breaking down two weeks ago.

The selloff paused at $37.97, with the stock retracing to the failure pivot last week. Note how this level corresponds with the 50-day moving average. This confluence adds predictability to the short-sale pattern, which will trigger when price drops through the late-October swing low.

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2. Pullbacks: Pullback shorts rely on weak rallies into resistance after a stock incurs obvious technical damage. This event can take place close to a high if there's a gap down, but more often it occurs within the context of a well-developed downtrend. In both cases, the setup triggers when price jumps above an obvious resistance level and then sells off.

SuperValu (SVU - commentary - Cramer's Take) rallied to an all-time high in June, posted a double top and entered a persistent downtrend. The decline broke 50-day and 200-day moving average support in mid-September while the broad market was spiking to multiyear highs. It rallied back to resistance several weeks ago, but it appears that the recovery effort has failed.

The twin candles at moving-average resistance have printed a "Tweezer Top" reversal. This bearish formation has been followed by a series of down days, as aggressive sellers renew their activities. The stock can be sold short on any bounce and held in anticipation of a test at the selloff low near $35 and eventual breakdown.

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3. Narrow range: Selling short in narrow-range patterns is less risky than chasing the market in either direction. This risk-conscious strategy looks for tight congestion at key support levels after a notable selloff. Enter the sell order within this pattern and place a stop to cover outside the two-day range in case the stock begins a larger-scale recovery.

CommScope (CTV - commentary - Cramer's Take) jumped to an all-time high in July and started to pull back. That decline accelerated into mid-August, with price breaking support at the 50-day moving average. It bounced strongly for the next month but that effort failed well below the old high. The stock then resumed its downtrend and broke the 200-day moving average last week.

Price has been congesting near the August low for the last three bars and could drop out of this pattern and resume its selloff at any time. Very strong volume on the decline predicts that any countertrend bounce in the next week will fail. A well-placed short-sale entry could yield 10 points of downside in upcoming weeks.

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4. Momentum entry: Shorting downside momentum is a risky strategy that can produce outstanding profits. The trick is to find an active selloff, like the bottom dropping out of the financial sector. Then ride the downside, while protecting your positions with percentage-based stop losses. Discipline is the key here, because these volatile issues are subject to violent short squeezes.

iStar Financial (SFI - commentary - Cramer's Take) hit a six-year high in February and started to pull back, as the subprime crisis posted front-page headlines. The stock dropped to a four-year low in August and bounced just below $30. That recovery stalled quickly, with price slowly working its way back to the summer low.

The stock broke August support on heavy volume last week and dropped five points before bouncing on Monday. Short-sellers should return quickly to this troubled stock and jam the downside through the recent low. How far can this downtrend carry? It's possible that a number of issues in this damaged sector will go bankrupt in the next six months.

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At the time of publication, Farley had no positions in the stocks mentioned, although holdings can change at any time.

Alan Farley is a professional trader and author of The Master Swing Trader. Farley also runs a Web site called HardRightEdge.com, an online resource for trading education, technical analysis and short-term investment strategies. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Farley appreciates your feedback; click here to send him an email. Also, click here to sign up for Farley's premium subscription product The Daily Swing Trade brought to you exclusively by TheStreet.com.

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