Bearish trendlines and candlestick patterns leading to short entries and exits

Trendlines are useful not only for determining the ideal time to get into a short trade but also for figuring out when to exit. This section focuses on the ways you can evaluate trendlines alongside bearish-trending candlestick patterns to pick the best time to cover a short.

Shorting and covering using a trendline combined with a candlestick pattern

Figure 15-3 features a chart of the stock for one of The Big Three — Ford Motor Company (F).

The candlestick pattern highlighted on the chart in Figure 15-3 is the bearish-thrusting line pattern, and it pops up in the midst of a pretty significant downtrend. The trendline is established based on the peak of the last bullish trend and the high a few days later. If you're looking for an illustration of the nature of the downtrend, this trendline fits the bill, and the stock price stays under this trendline for some time.

You can see that midway between the pattern and where the trendline is broken, the high comes perilously close to pushing above the trendline at one point. That event offers a trendline validation of sorts. Then a few weeks later, the trend flattens out, and the trendline is broken. If you short this stock, that's when you want to get out of the trade.

Determining trading levels with trendlines

Trendlines are great indicators for a lot of reasons, but one slightly tricky feature of trendlines is figuring out how to use them as exit stop levels. This judgment is difficult because they move every day. How can you deal with that? You have a couple of choices:

^ First, you can draw a new trendline every day, to keep up with the changing price action. This method works because your line moves consistently with the trend, and you can place corresponding stop orders that are good for that day only. But that method can also be taxing, because you have to commit to changing the trendline every single day.

is The other option is to set up a stop that gets you out of the trade only if the close for a day is above your trendline. That strategy eliminates the need for a daily trendline change, but it does require that you check your chart toward the close of each day.

Some traders also like the second option because it keeps them from getting stopped out of a trade if the price makes a little run above the trendline, but other traders contend that the price can rise dramatically (and close quite a bit higher) and erase profits or even cause losses before the stop took effect. It's up to you to decide which method works best with your trading strategy and style.

Figure 15-3:

A chart of F with a downtrend line and bearish-thrusting line pattern revealing a short exit.

Figure 15-3:

A chart of F with a downtrend line and bearish-thrusting line pattern revealing a short exit.

One final note on the chart in Figure 15-3 before I move on. Astute chart observers will notice a bullish reversal pattern at the bottom of the downtrend; did you catch it? It's the bullish three outside up pattern, and it signals that the downtrend is about to change directions and head up. You can always use a reversal pattern as an exit when it shows up on a chart, and in this case it helps you lock in just a little more profit on the short trade. Also, if you're so inclined, you may use this bullish pattern to establish a long position.

Exiting one trade doesn't mean that you have to stop working with a particular security for any period of time. If you're in a trade and riding a prevailing trend, and you spot a trend reversal candlestick pattern, don't rule out the possibility of exiting the current trade and jumping right back in with another trade that rides the trend in the opposite direction!

Shorting and covering with a downtrend line and bearish pattern

I'll offer one more example before I wrap up this explanation. Figure 15-4 is a chart of the futures contracts that trade based on the Swiss franc level versus the U.S. dollar.

Figure 15-4:

A bearish-trending candlestick pattern and a downtrend line reveal a short exit on a chart of the Swiss franc futures.

Figure 15-4:

A bearish-trending candlestick pattern and a downtrend line reveal a short exit on a chart of the Swiss franc futures.

The contracts are in a downtrend when the bearish-thrusting line pattern shows up. The trendline I drew on this chart leaves a lot of room for retracing to a stop, but if you see this signal and decide to take the risk, your reward can be pretty amazing.

Soon after the exit, this chart becomes a little heartbreaking for the shorts because the stock moves even lower and it's clear the shorts could've made additional profits. It's frustrating, but you have to make sure that you don't let situations like this get you down. As I say time and time again, it's better to stick with trading rules and exit when it's prudent than to break rules, take risks, and lose your shirt in the long run.

Combining Moving Averages and Bearish-Trending Patterns for Short Situations

The moving average is another technical indicator you can combine with bearish-trending candlestick patterns to help figure out when to enter and exit your short trades. You can read all about moving averages (and several other technical indicators) in Chapter 11, but, broadly speaking, a moving average is the average of the closing prices of a security over a certain period of time.

Moving averages are very useful in confirming trends, and that functionality makes them good bearish-trending candlestick pattern partners. Read on to find out more.

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