A Solid Short Play Amid the Fallout

 | May 23, 2013 | 9:00 AM EDT  | Comments
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You can always count on the Federal Reserve to shake things up a bit! On this note alone, Fed chief Ben Bernanke did not disappoint.

The day began like many others we have seen, with the market continuing to push to new highs for the year. But, within an hour, the indices were already striking the upper-channel resistance that has held well throughout the month.

Then the Bernanke headlines began to pour in.

Perhaps the most influential aspect of Bernanke's testimony came from hints that the Fed may be considering a reduction in the pace of its quantitative easing program: He noted that the current fiscal policy may actually be restraining growth. This was not the reassurance for which the market had been hoping.

With the indices already extended, and once again pushing on resistance levels intraday, it only took a nudge for things to begin to fall apart. The Fed, by essentially admitting that its policies haven't been working, rendered the bulls a death blow. By the end of the day, the market had experienced one of its largest intraday price swings of the year. The action established a strongly bearish price bar on the daily time frame, as well in the form of a candlestick pattern known as "shooting star" -- on both the daily and 90-minute charts. The large influx in volume confirmed the reversal.

SPY -- 90-Minute | Source: TradeStation

Source: TradeStation

Many stocks had already started to turn over in the course of the past week as concerns had begun to take hold regarding an imminent corrective move on the weekly time frame. While Wednesday's action has served to confirm this fear, it's still not too late to take advantage of this changing sentiment.

One strategy in particular works very well in times like this -- one that I have dubbed an "avalanche." The pattern begins with a stronger-than-average pullback off highs, followed by a period of congestion. This congestion typically hugs a moving average, such as the 20-day exponential moving average, or the lower end of the security's trading channel. As the security congests, volume will ideally decline. Your trade trigger comes as the congestion breaks lower.

Over the past week this pattern has shown itself a number of times, for example, in Akamai (AKAM). On the chart below, in each of the three highlighted setups, the trigger came for the short trade as the blue line broke lower. Notice that, in every instance, most of the trading was taking place in the lower 50% of the downside move that preceded the congestion. Those moves are marked in red. The third setup, which came on the larger time frame Wednesday, was the one that also triggered the channel break on the daily time frame.

Akamai (AKAM) -- 15-Minute
Source: TradeStation

This is one of my favorite reversal strategies, even though technically it's a continuation of the reversal that began with the pivot off highs. Right now the market again needs a chance to rest intraday. But, over the next several sessions, look for stocks that are congesting in the lower portion of Thursday's selloff. These will be the ones to watch for strong downside continuations as we head into next week. Those that underperformed the broad market prior to Wednesday, but are still trading at or near this year's highs, will have even stronger odds for success.

DuPont (DD) is among those I am watching closely. The stock has shifted momentum over the past several weeks, although it has continued to make new highs. Volume never confirmed those highs, and each one has served as a new trap for the bulls. Once the channel breaks on the downside, it will be easy for shares to fall quickly. Initial intraday support will hit around $54.50, but the next major daily support level won't be until $53.

DuPont (DD) -- 90-Minute | Source: TradeStation

Source: TradeStation

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