BEARISH GAP DOWNS

Oftentimes, a stock will gap down in the morning and leave nervous traders wondering whether or not it is going to come back and fill the gap it created. These bearish gap downs are usually precipitated by unanticipated bad news a company puts out, which catches the market off guard. Fund managers never like being surprised with such news and do not want to hold onto losers in their portfolios.

It is precisely for this reason that, when trading in the gap, you need to watch the print (price and volume information

140 Phase I: Basic Trading Tactics

retail side of the trade. I would never short a mega–gap down at the open, as the risk-to-reward ratio is just horrible. How-ever, if a number of trades are going off at just a few hundred shares, the market most likely has been expecting the news and is waiting to shake out those on the retail side who want to sell their positions. I am not suggesting that with the One Shot – One Kill Method you join the retail side in this type of trade, as this practice alone can be very hazardous to your wealth.

However, stocks that experience a mega–gap down and don’t recover can set up for nice shorting opportunities once the retail shakeout has happened. Once the stocks make a shallow intraday rally higher and subsequently moves lower, you are given a pivot from which to work—and a much better place to set your stop on the trade.

With that being said, if the news is met with large prints at the open, such as share sizes larger than 2500, then there is a good bet there is some force to the selling. As always, wait for the pullback and see how it responds. If the pullback is met with more selling, then get short and set your stop on part of your position 25 cents above the high of the day, and the other part above the most recent pivot high. This strategy will give you a good point to get short, with a low-risk basis, and should help prevent you from getting killed on any kind of coun-tertrend rally.

Examine the move with International Rectifier Corporation (IRF), which is illustrated in Chart 6.7. You can see that just after the company announced it would not be making earnings, there was a tremendous amount of stock that was sold off.

CHART 6.7 When a mega–gap down happens and the stock can’t fight off the initial onslaught of sellers, it is a good sign that a sustained down trend will follow over the course of the next few days. International Rectifier Corporation (IRF) opened near the highs and closed near the lows, which suggested further weakness.

142

(EMLX), one of the Nasdaq’s biggest high flyers, came out with some less-than-flattering news for the Street.

The stock was crushed on a huge surge of volume. With this type of stock play, a more experienced short seller is required to enter. But anyone can use these tactics to unload a long position that has gone against her or him. The chart clearly shows that the public was obviously not expecting the news, and because of the inevitable selloff, this point looked to be a good place to get short. However, like all the other trades talked about, if you can’t manage to get in the first move, don’t chase the stock, as patience and discipline will usually reward you with a good sec-ond chance.

This strategy can also be used even if you are not comfort-able shorting stock. If you own stock that gets hit with bad news, you have two options: Be like the rest of the sheep and sell at the open, and fight to get a decent fill on the trade, or see how the stock handles the pullback. If the stock manages to rally back near the open but begins to roll over, that is the point when you are usually best served to dump your shares. If you are a real trader and see all of this happening right in front of your eyes and still do nothing, then it is time for you to stop trading for yourself and invest your money in a respectable, high-yielding hedge fund. Until that time though, all trading decisions made by you, the trader, should be based solely on your own finding of facts, in which your emotions shouldn’t play a part.

To summarize, for bearish gap downs do the following:

1.Watch gap down and print size to determine if there is

CHART 6.8

From bad to worse: Investors wish they’d had stayed in bed as EMLX cruises through Fibonacci support and falls over 90 percent from its highs.

144 Phase I: Basic Trading Tactics

dough to buy houses in the Hamptons.

Bearish gap ups provide yet another good shorting opportu-nity, often arising on an intraday basis. A stock that is in a pro-hibitive down trend tries to attract buyers who, early on, are doing some bargain hunting. The stock gaps up in the morning and tries to make a run up. However, as is usually the case with a bearish gap up, there is no real support for the move. The bears use the opportunity to sell into the rally. It is at this time that you should pay close attention to the action surrounding this stock. If after the first half hour of trading the stock has held onto its gains, then it appears there may be some legiti-macy to the move. However, if the stock can’t break above the open, then you can use this as an opportunity to short the stock and set the stop a 1/4 point above the high on the day.

In many instances, it is more profitable to get in if the gap up occurs at a major price target following a sustained rally higher.

Often, following a rally over several days, the rest of the retail sheep get led to slaughter, as the market will look at a mega–gap up opening based on some economic news or that maybe Asia ral-lied strongly in the overnight session. The euphoria gets going and everyone is feeling good about owning stocks again. This is where you use your Fibonacci price targets and objective techni-cal analysis to look for a good, low-risk entry point.

In situations like these, market makers expect the demand to be higher, due to market conditions, so the stock will gap up.

However, for stocks in down trends, this point can be used as an excellent opportunity to short. The rules of entry are the same.

gauge the pullback to see how strong the trend is. Once the stock starts heading lower again, get in, and place the stop either above a pivot point or above the high of the day, depending on the time frame in which you are trading the stock.

The second, and most powerful of the types of bearish gap ups occurs following a three- to five-day rally, in which everyone is convinced the real move is on and doesn’t want to be left out of the fun. The introduction of this book highlights that type of sce-nario. Akin to the first type of bearish gap up, the futures are bid up on relatively light volume and market makers do their best to knock out the illiquid ask orders on all the electronic communi-cations networks (ECNs). They do so in order to get everyone hyped about the move higher, just before they fleece their wait-ing lambs and turn them into lamb chops.

The market will typically gap up, and hang out for a little while, before the music stops and there are not enough chairs for everyone to sit. The move down can set up a tremendous reversal.

It is during this type of bearish gap up when the use of the TRI is critical in spotting divergences on the shorter time frame. If the gap up occurs at a major Fibonacci resistance point, then that sit-uation adds even more fuel to the fire, as far as taking on a short position. Once you see the divergence and the market beginning to struggle, phase into the trade on the short side. The moving averages will have not caught up with the move yet, so set your stops above the high of the day, or the area of Fibonacci Friends.

After you get short, watch the first bounce. If it makes a lower high, and rolls from there, then phase in with the rest of your position. Put your stop above the high of the day, and enjoy the ride. I have seen many bearish gap ups following huge runs, lead to two- to three-day reversals. Being aware of these opportunities can help greatly with your play selection and overall profitability.

Look at the situation with Qualcom (QCOM), which is illus-trated in Chart 6.9. The stock had been on a phenomenal tear for all of 1999. Some positive analyst comments came out on the stock before the bell opened and the stock had a huge gap up.

However, it was all downhill from there, as the gap up was met with sellers galore and the price of the stock was crushed.

As with a bearish gap down, you need to watch the volume on the stock, to see if the move up is making large prints on the

146 Phase I: Basic Trading Tactics

CHART 6.9 What are also known as rally killers are mega–gap up days following a prolonged move higher. This action sees the market open at highs and close near the lows of the day. These gap-up days are a warning sign to unload your long positions and look at some short-term short entries.

buy side or if the large players are hitting the bid. If that is the case, I like to look for share size of more than 2500 shares. Most traders will tell you to watch block trades of only 10,000 or more shares; however, I think this maneuver is a mistake. A not uncom-mon tactic—in fact, one frequently used—is for institutions to route their orders in smaller chunks, for the sole purpose of hid-ing their intent. Therefore, I watch the speed of the time and sales as much as I watch the size of the volume.

Market makers and specialists are very skillful and adept at taking the retail traders’ money, and they use gap ups and gap downs to accomplish this objective. The market makers have a very good understanding where the order flow is coming from and at what price there will be an equilibrium of buyers and sellers.

For this reason, you would be much better off before making a trade under these conditions to wait for at least 10 minutes at the open and let the trend emerge. Picture yourself in this situation as acting like a sniper in a war zone, waiting patiently and watch-ing as the setup unfolds, and then, and only then, quickly pullwatch-ing the trigger.

Most investors spend their lives wishing for stocks to go in only one direction. I, on the contrary, whether as a result of my taking the road less traveled my whole life or realizing that ning short trades usually compounds my money faster than win-ning long trades, actually enjoy going short more than going long.

Despite whatever preferences you may have, the best traders in the world can (and do) trade both ways. They are not caught up with their egos and about being right. They simply look at what the market is telling them and act on what is actually happening.

If and when a trading situation presents itself, they attack.

Period. Otherwise, there is just a lot of chart watching going on.

There is something to be said for profiting from a major downturn. It is similar to selling a stock and then watching it go down, but much more rewarding. If the market is going to go down (and, believe me, sooner or later it will) before rising and dropping and rising again, why not learn to profit from these regular occurrences? By employing the One Shot – One Kill Method, you will be prepared to profit from significant market moves, no matter the direction, exactly as many professional traders do every day.

148 Phase I: Basic Trading Tactics

• Look for a Fibonacci price level or inflection point which may provide a good entry

• Enter on a shorter term bearish formation to at least put the short term trend on your side.