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Pick Good Candidates to Short

The major indices have dropped a long way since mid-May, but it still isn't too late to sell short. Many of the sectors that held up well in the last month are now rolling over and joining their weaker cousins in notable declines. So get in there and take the short-sale plunge so you don't get left out while the market is rewarding this classic strategy.

Momentum short-selling is the most popular method to play falling markets, but it's also the easiest way to lose money. In this approach, traders sell stocks that are dropping at a rapid pace and hope they don't get caught in inevitable short squeezes. These fast-moving positions can offer great profits but are very hard to time perfectly.

This is related to the dangers of "short overcrowding." Simply stated, many traders notice that a stock is falling hard, and they mindlessly jump on board. Sooner or later, that side of the market gets filled to the brim with weak-handed players trying to grab the low-hanging fruit.

These short-sellers create buying power because they're nervous nellies -- easy to shake out. Contrarians see the telltale signs of short overcrowding and target those markets in an effort to force the crowd into a covering panic. It's no different than a few cows in a big herd getting freaked out and starting a massive stampede.

So tread lightly when looking for new short sales, and focus on stocks that show the characteristics of impending declines, rather than ones already stuck in big downtrends. There's less competition, and you'll be covering your trades for decent profits just as the crowd notices the selloff and starts to chase it into yet another overcrowding scenario.

iShares Russell 2000 Index Fund ETF (IWM)
Click here for larger image.
Source: eSignal

The iShares Russell 2000 Index Fund (IWM) ETF spiked up to a three-month high at $63.25 in early June, rising above 200-day moving average resistance. It held above that level for three sessions and then sold off into the late-May swing low. The next uptick stalled at the 200-day barrier and gave way to another downturn.

This rollover has completed a bearish head-and-shoulders topping pattern, with the neckline at $71.50. A break at that support level should trigger a major decline that eventually fills the April 15 gap at $69. Longer term, this instrument looks like its gearing up a critical test at the March low.
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