"Every day, I assume every position I have is wrong ... if they are going against me, then I have a game plan for getting out."
-- Paul Tudor Jones
It is every coach's job to have a game plan for his or her team, and it is every trader's job to have a game plan for each trade. Today's game plan involves luxury fashion accessory brand Coach Inc. (COH) .
Coach was off to a great start this year, rallying from $36 to $48, a gain of 33% in just over six months. Then the stock was hammered after Coach reported fiscal fourth-quarter earnings in mid-August. Investors were concerned about the company's gross margins, which declined from 69% of sales to 67%. Coach lowered projections due to the Kate Spade brand's integration into the company.
Even though Coach is now off its highs, there is still potential for more downside ahead. At least that's what the chart is telling us. Coach dropped sharply on heavy volume, and now the bulls only can manage a meek rally on dwindling volume (shaded yellow). That rally is taking the shape of a loose bear flag (circled). The pattern suggests that Coach could fall to the mid-to-high $30s.
Another problem with Coach's chart from the bulls' perspective is its island reversal pattern. Take note of the gap higher on May 8 (point A) and the gap lower on Aug, 15 (point B). If you went long Coach in between those dates, you purchased the stock between $44 and $49; in other words, you are "stranded on the island," so to speak.
Why does this matter? Trading is at least partly a game of psychology. If we know that there is a large group of traders who recently entered into what is now a losing position, then it's reasonable to assume that some of them are going to sell into rallies. This behavior should continue until everyone who wants to get off of the island manages to escape.
With its bearish pattern and a large group of underwater buyers, my plan is to short Coach. Referencing the quote at the top of the page, what if I'm wrong? No game plan is complete unless we have an exit strategy.
I've drawn a red dotted line at $44, inside the gapped area and just above the high of the long red candle. If the price enters the gapped zone, there is a risk that it could continue higher and fill the gap. I'm not willing to take that risk, so I'll buy to cover if the price rises above $44.
This commentary originally appeared on Real Money Pro on Sept. 6. Click here to learn about this dynamic market information service for active traders.