A New Shorting Strategy

This column was originally published on RealMoney on May 11 at 11:00 a.m. EDT. It's being republished as a bonus for TheStreet.com readers.

For years, I've separated my trading strategies into different broker accounts.

This division of labor keeps my head clear when the positions in them start moving around. In essence it's a risk-management tool, because I'll often trade 10 or more stocks at the same time.

Right now I'm using my main account for short-term trades, where profits or losses are taken with little hesitation. Conversely, the stocks in my second account get more wiggle room, because it's designed to let positions run. And to stay happily married, I keep all the family money segregated in a third account, far away from my frantic fingers.

I opened a fourth account last month with a handful of speculative capital that just freed up. It's exciting, because this one gives me the opportunity to try out a new approach. For years my short sales have been integrated into other accounts. So I've designated this one as "short only," with the objective of holding short sales through the inevitable whipsaws.

Short sales tend to work better in longer time frames, especially in jumpy markets.

There's considerable motivation for short-term players to fade every selloff we get these days. So the most vertical decline is typically followed by a squeeze that shakes out late sellers. But sooner or later, gravity kicks in, and these broken issues continue to decline.

My early positions applying this new strategy have been encouraging, but it's still a work in progress. In particular, I'm still not settled on the chart profile that best reflects the downside aims of this account. To this end, let me share five weak stocks I've been watching as potential short sale candidates -- Mattel(MAT), SPX(SPW), Foundry Networks(FDRY), Northrup Grumman(NOC) and Iron Mountain(IRM).

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Mattel

These aren't the best of times for Barbie and Ken. Toymaker Mattel dropped off a multiyear high at $21 about a year ago and has been moving lower since that time in a persistent decline. A countertrend rally earlier this year stalled out at $18.32, and the stock rolled over in a head-and-shoulders topping pattern.

Shares broke the neckline of this bearish pattern earlier this week. This violation should trigger a selloff that fills the February gap and tests the 2006 low at $14.75. In turn, I suspect that any bounce at that support level can be sold aggressively for an eventual breakdown that sends the stock into single digits.

SPX Corp.

SPX is a high-risk short play with significant profit potential. The stock gapped up to a two-year high last week but then closed at its lows. It then gapped back down the next morning, completing an abandoned baby candlestick pattern. This formation signals a major downside reversal.

The vertical selloff also began right at a significant 2004 top. The combination of these bearish elements suggests the stock will enter a downtrend that could reach the upper $40s by this summer. I don't think this pattern shows an easy entry right now, so it's probably best to wait for a failed rally attempt into that monstrous gap.

Foundry Networks

Foundry Networks is engaged in an interesting game of 50-200 pinball. This is my label for a stock that has broken its 50-day moving average but is still trading above its 200-day moving average. It's a transitional pattern that often leads to a major breakdown at longer-term support levels.

The current bounce should fail at of near current price levels and set up a breakdown through the April low. Early short positions can be taken just below the 50-day moving average, with tight stop losses. Traders can cover positions into longer-term support or hold on for a larger-scale breakdown that might carry to the October low at $11.

Northrup Grumman

I'm playing a wait-and-see game with Northrup Grumman. The stock broke a six-month trendline with a gap-down selloff two weeks ago and bounced just below the 50-day moving average. It remounted that support level quickly and is now testing resistance. Look closely and you'll see a bear flag pattern in the recent recovery.

A breakdown from this countertrend bounce should test the April low at $66. In turn, that support should fail and yield a decline that carries to the 200-day moving average near $62. There could be several profitable short entries along the way, but a tightly managed position taken on a reversal near current levels shows an excellent reward-to-risk profile.

Iron Mountain

Iron Mountain rallied to an all-time high last November and started to pull back. That slow decline sped up last week when the stock gapped down on heavy volume, breaking support at the 200-day moving average. Price has been wobbling back and forth since that time, trying to figure out what to do next.

The best scenario for short-sellers would be to sell a failed rally into the big gap below $39. It is unlikely that price will be capable of moving back into this contested level after the next downside reversal. In turn, that failure should put enough selling pressure on the stock to carry it down to multiyear support near $31.50.

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