Lot of negativity is already baked in

In spite of the summer rally, most stocks are still stuck in lower end of their ranges. So lot of negativity is already baked in to these price levels.

If you are looking at shorts, one has to look for high risk reward trade, it is easier to find those trades at the end of long and sustained move up. At this stage in the market three types of short trade should work.

1 Fresh breakdown of stocks which had held on to their relative strength. Oil sector is an example of that. But the reward on that trade may be limited because unlike the housing sector which reached extreme level and started down, in this sector most stocks will have a pullback and they will settle down in multi year or multi month range. The oil sector is cooling down, its fundamentals are not deteriorating rapidly.

2 Breakdown from consolidation at lower end of range. The homebuilders are at this stage. The question is how much more is remaining in that trade. Or is that the trade which offers the best risk reward. Here there is so much negativity and the short trade is so overcrowded that many value types will be tempted to start supporting it and shorts will start covering if they find other opportunities. Also you have to remember the large sums of money in the market from large mutual funds and other institution has very strong value orientation and long term holding bias, so they may be looking 3-5 years ahead and picking these bargains.

3 Rallies from bottom breaking down. Now these trades might have best risk rewards for shorts. Something which has rallied 25-50% after a significant decline is an ideal candidate for short entry. They will revisit their lower end of range. The technicians call it double bottom if it does that and then again rebounds.

I have around 60 stocks which meet this third criteria. I found them using a quantitative screen, screening for % drop after a significant rally and they have rallied in recent times. I am watching them like hawk for possible low risk short entries.

In the meanwhile I also have my watch list of longs ready. Over the 100 years of stock performance, the surprises have always been on the upside.

No comments: