Trade Down Moves without Going Short
05/28/2012 9:00 am EST
Inverse leveraged ETFs can be effective tools for traders looking to capitalize on short-term market weakness, writes Deron Wagner, reviewing a recent winning trade targeting the semiconductor sector.
As a technical swing trader whose trading strategy is based on following the dominant trend of the market, I am not bothered when the stock market shifts direction to the downside because my proven market timing model continually keeps me trading on the right side of the market (or out of the market altogether, at times).
Last week, as the main stock market indexes fell sharply, I profited from several short and inverse ETF trades. In this article, I will walk you through the technical anatomy of one of last week’s successful swing trades.
Just as my trading strategy for the long side of the market is focusing only on strong stocks and ETFs in an uptrend, my strategy for the short side of the market is to target weak stocks and ETFs already in a downtrend.
One ETF that was already meeting that condition at the beginning of last week was the Market Vectors Semiconductor ETF (SMH). The annotated daily chart of SMH is shown below:
Since forming a peak in March of this year, SMH has been in an intermediate-term downtrend, as indicated by the series of “lower highs” and “lower lows.” The 20-day exponential moving average also crossed below the 50-day moving average about a month ago, thereby confirming the intermediate-term trend reversal.
Additionally, the 50-day moving average is already sloping lower, which helps to confirm the trend reversal. After several successful tests of support at the $33 area, SMH finally broke below this level on May 8. This caused the prior support level around $33 to become the new resistance level.
Because it was such an obvious break of support at the $33 area (the dashed horizontal line), it became a false trigger for a short sale. Traders who sold short the initial breakdown on May 8 were likely shaken out of their position three days later when SMH rallied into and probed above resistance at $33. However, the bearish reversal bar of May 11—right at key resistance—provided a low-risk entry on the short side if SMH traded below that day’s low.
Rather than actually selling short SMH below the low of the reversal day, I decided to buy the inverse and leveraged Direxion Semiconductor Bear 3X ETF (SOXS) instead. Because leveraged ETFs are based on derivatives, they are not designed to buy and hold. However, these types of ETFs are ideal vehicles to capture short-term, momentum-based moves.
See also: The Leveraged ETF Safety Kit
The chart below shows the set-up in SOXS, which was similar to SMH, but inverted. Notice how the 20-day exponential moving average has crossed up above the 50-day moving average, which is also sloping up. You will also notice the same false breakout bar that led to a pullback. Therefore, our low-risk entry point was above the high of that reversal bar.
After the May 11 reversal bar, the following day’s price action was not convincing, so I held off on buying until there was more price confirmation. This occurred on May 15, when SOXS rallied above the high of the May 11 reversal bar and rocketed to a 12% gain on just a three-day holding period.
Although I yielded solid profits on the short side of the market last week, now is the perfect time to be patient.
Opening new trades at the current levels involves taking on too much risk with minimal upside potential (negative reward-risk ratio). Nevertheless, select currency ETFs such as the ProShares UltraShort Euro (EUO) or commodity ETFs like the Deutsche Bank Gold Double Short ETN (DZZ) (both pointed out as potential pullback entries) could be nice plays because they have a low correlation to the direction of the overall equities markets. Otherwise, cash is king and a very valid position.
By Deron Wagner, founder and head trader, Morpheus Trading Group
We’ve had a nice string of winning trades on our Wagner Daily swing trading newsletter. Check it out today.