Bear Market (cont.)
For short sellers, greed plays a role in a declining stock as they salivate at the increasing equity of their account balances. Short sellers are not immune to fear in a primary downtrend. Short term rallies can come suddenly and quickly in a downtrend and the fear of evaporating profits motivates short sellers to buy. There seems to be a general mistrust of the shorting process and, as such, they are often very quick to cover their positions at the very first sign of any short-term strength.
I tend to be very quick to cover short positions because some of the strongest rallies can occur in a downtrend. Holding a short in the face of such an advance can lead to quick and dramatic losses. I would rather cover my position with a profit and stand aside during short-term, and often violent, rallies and then re-enter the position as the stock begins to weaken again. It is my experience that short-term counter trend moves in a primary downtrend can occur so quickly that trading short is more difficult than long.
Because of the great volatility in a bear market, shorts generally should be traded more aggressively than longs would be in a bullish enviornment.
For a stock in a confirmed downtrend, the rallies are generally feeble, low-volume moves that quickly fail as more frustrated buyers come to the realization that the bottom has not been found. A weak stock is similar to a boxer who continues to stand up to his opponent after repeatedly getting knocked down. The stubborn fighter will ignore the chant of his trainer to “stay down,” much the same as buyers keep coming back to the stock hoping to catch the bottom. These participants ignore the shouts of the market to stay away. Yes, the market does “shout” to us, and the screams are represented by the declining moving averages. When a stock experiences short-term rally, it finds a renewed sources of supply at a level which is lower than the last time the sellers took control’ this action is represented by the lower highs on the chart. And, of course, a lower low is created as long holders sell out in disgust as they realize they were unable to correctly make their purchases at “the low.”
Stocks in downtrend can decline very rapidly and their decline leaves broken dreams and account balances for those foolish enough to attempt to pick a bottom.
News & Gaps
When a stock has established a series of lower highs and lows, it will sometimes gap higher when there is a news release, analyst upgrade, and announcement of a share repurchase plan by the company, or some other fundamental development.
Sudden rallies in a downtrend can sometimes tempt the most disciplined traders to get long, but it is common for today’s hopeful buyers to become tomorrow’s fearful sellers as they realize they have been trapped in a stock where sellers have been waiting in the wings for the liquidity to exit.
Do not trust gaps higher in a downtrend, as they have a nasty tendency of reversing. Instead, monitor shorter-term time-frames for short opportunities to enter a short as the rally fizzles out.
When stocks in downtrends gap higher, do not chase the temporary strength, as it typically fails to hold. Bottoms are a process, not an event.
Paradoxically, it is often “bad news” which motivates temporary strength in a declining stock. When a stock has declined for several days without a solid reason and then bad news is released, there often is a knee-jerk sell reaction by the less-informed long holders as they realize the fundamental picture may not be as rosy as their previous research had indicated. When a technically week stock gaps lower on news, forward-looking short sellers who anticipate is often will take advantage of the liqudity provided by the mini panic and cover some, if not all, of their positions.
It can be tempting to get long a declining stock because you feel the stock is “down too much.” This thinking is based on the hope that sellers will “come to their senses” and recognize the value. They won’t. Logic and reason get thrown out the window when participants act on emotion. Recognize that a stock in a downtrend will bring about those emotions at very inconvenient and financially damaging times for those who were not quick to sell at their first signs of trouble. A stock is never down too much when there is a simple absence of demand.
The end of a decline often finds climatic selling action as the last of the stubborn longs liquidate in fear and disgust. Other sidelined participants who have not been involved in the stock may succumb to the temptation of selling short as it becomes “obvious” that the stock is in trouble.
The increased volatility near the end of a decline will begin to taper off as 1) emotional participants get shaken out of their positions and 2) more methodical selling actions of the remaining large positions are gradually overwhelmed by the accumulation of players who are positions for the next cyclical move higher.
When a stock begins to show the first signs of higher lower (but not higher highs) it is likely the stock will enter the boring stage of accumulation. The end of a decline may be a relief to those who stubbornly stayed long, but that relief is often slowly replaced by a feeling of defeat as the stock turns neutral.
===
Brian Shannon is author of “Technical Analysis: Using Multiple Timeframes” which is available by click on the link below. You can also see Brian’s video technical analysis of the markets for free at www.alphatrends.net
