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Investment managers and authors Gil Morales and Chris Kacher tell MoneyShow.com how they use the head-and-shoulders pattern to identify short candidates. They also detail their method for using inverse ETFs.

Kate Stalter: Today I’m speaking with Gil Morales and Dr. Chris Kacher of VirtueofSelfishInvesting.com. Last week you hosted a web chat here on MoneyShow.com about shorting stocks.

And, shorting is something that’s obviously a topic that a lot of investors are interested in these days, but a lot of people really don’t know how to go about it in a way that makes sense. So can you sum up your methodology?

Gil Morales: Yeah, well, our methodology differs from most short sellers, who I think come from what you might call the school or the university of “I am smarter than the market.”

We don’t really try and bet on fundamentals, so take a fundamentally based short side position on a stock, based on that rather than paying attention to the trend. So for example, individual, high-profile hedge-fund manager shorting Netflix (NFLX) on the way up are really trying to do so on the basis of some fundamental theme that they think is going to overcome the stock at some time.

But the bottom line is: With shorting, it’s just like going long. You want to go with the trend, and so the only time we go short is during a bear market, and the stocks that we’ll pick on during the bear market are the same exact stocks that we may have, or would have been looking at on the long side during the bull phase of the prior market, just before the market topped and went into a bear phase.

So in essence, your buy list during the bull phase becomes your short-sale target list when the market goes into a bear trend. So that’s basically how we approach it.

We wait for stocks to start to break down and we look for patterns that signal—that’s like head-and-shoulders top, late-stage failed phases, some other more bizarre set ups like Rocket Stocks, which Dr. K has done research on, as well as POD [Punchbowl of Death] formations, which are another type of Rocket Stock formation; you might think of them that way, but that’s basically how we operate.

Kate Stalter: Now, Chris, Gil was just talking a little bit about some of the technicals that you look for. Can you say something about that?

Chris Kacher: Well, a lot of times when a stock has been a leading stock, and it starts to show signs of topping out, it tends to get more volatile, and head-and-shoulders-patterns—a good head and shoulders pattern—that is showing possible topping action is going to be a very strong bearish pattern, because what you’re going to see is more volatility at the top.

It’s almost like there’s a tug-of-war between the bulls and the bears as a stock is topping, and sometimes that traces out into a head and shoulders. The ideal head and shoulders is where the right shoulder is much lower than the left—in other words, a stock has had a serious break to the downside, sometimes in the form of a gap-down.

So you get a head and shoulders that’s kind of lopsided on the right side of the shoulder, and then the stock will sputter around and it will often give an entry point on the short side, and oftentimes a stock is trading under its 50-day by that point.

Gil Morales: Yeah, exactly, so, and you can see a pattern. For example, you look at Netflix forming a head and shoulders before it broke down a couple months ago. You saw Green Mountain Coffee (GMCR) doing the same thing.

There’s been several of these types of patterns; I think even Aruba Networks (ARUN) is another one. Amazon (AMZN) is actually, looks like it’s just starting to break down from a very narrow head-and-shoulders formation that it had formed over recent weeks, so that is definitely the pattern to be looking for.

Continued…

Tickers Mentioned: Tickers: NFLX, GMCR, ARUN, AAPL, AMZN