The End of a Rally Can Be a Good Thing

Short swing trades in Aflac and Plug Power illustrate how to play this delicate situation.
Author:
Publish date:

It's time to start thinking about short sales again -- but take your time. Options expiration has a nasty habit of holding up weak stocks and pulling down strong ones, especially when at the end of a hellish month. If you have a delicate stomach, you might want to wait and get a fresh start on Monday morning.

We are finally seeing signs the post-Sept. 11 bounce is over. Don't take this the wrong way: Just because a market stops going up, that doesn't mean it's headed straight down. Sideways is a real direction, and one that makes a lot of sense after a big price move.

The best thing about a rally's demise is we get to choose trade setups from both sides of the market again. Crosscurrents offer perfect conditions for swing trading. This has to do with the return of buying and selling equilibrium. In this balanced environment, price tends to go where it's supposed to go with fewer shakeouts or fakeouts.

The last thing I want to do after expiration is short big-cap tech stocks. It's way too risky for a risk-averse trader like myself. Strong rally momentum can take weeks or months to dissipate, even if the averages don't move higher. And earnings season offers the perfect setting to initiate sudden and very painful short squeezes.

So the safest selling opportunities are best found off the beaten path, in smaller-cap stocks and less-obvious names. But first we need to find a decent price pattern to short.

Source: qCharts

Aflac

(AFL) - Get Report

shouldn't go up from here, but it may not head straight down either. First the good news, at least for short-sellers: The volume pattern is terrible. Earlier this month, a two-day selloff on three times average volume killed the bear bounce off the low at $23. Few buyers have come in to support the stock since the event.

Notice how the vertical drop also failed the 50-day and 200-day moving averages. With a little luck and good timing, we'll get a price break equal in length to the first selloff. Many swing traders refer to this setup as a 1-2-3 pattern: breakdown, pause and breakdown again.

The bad news is that price is still grinding back and forth between two up gaps. You can see how conflicting forces through these levels are building the price range we're hoping will break in our favor. But there are no guarantees.

Is the short sale worth it? With a little luck, we can take home about 3 points. That doesn't sound like a lot, but look at our risk. A logical stop can be placed just above the congestion at $27. That gives us a reward: risk ratio of more than 3 to 1. Not bad for a quiet corner of the

NYSE

.

The most obvious trades are often the best ones.

Plug Power

(PLUG) - Get Report

had only three good days after the markets reopened from their unscheduled vacation. Since that time, PLUG has drawn a very ominous-looking descending triangle. If the bottom falls out at $8.75, it could easily collapse all the way back to its September low, $6. That's a 30% move on a single-digit play that might last only two or three days.

Source: qCharts

There's a rally gap to contend with once again. This suggests the breakdown could start with a gap down through the same level. The best short sale strategy would sell the first rally into the broken support level. Be careful if you're thinking of selling short within the triangle itself; PLUG can be thin and illiquid at times, and also has a nasty reputation for short squeezes.

Stay flexible. The best trade for this pattern may not be a short sale at all. The retail technician expects the descending triangle to act in a certain way, but market dynamics rarely play out as expected. If PLUG breaks down but then jumps back above $9, don't hesitate to cover your short sale. And if price suddenly rallies and breaks out the top of the descending highs, you've just witnessed one of the best buying signals in swing trading.

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. At the time of publication, Farley held no positions in any of the stocks mentioned in this column. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Farley appreciates your feedback and invites you to send it to

Alan.Farley@TheStreet.com.