Deciding when to get in and out of shorts

Knowing when to exit a trade can be as important as knowing when to make an entry, and luckily the stochastic indicator — when used in combination with bearish candlestick patterns — can provide you with guidance for covering a short. Truth be told, the stochastic indicator actually does an okay job on its own, but when you use this indicator correctly with candlesticks, the odds of success are in your favor. To close out this chapter, I present a couple of examples of how you can use the stochastic indicator with bearish candlestick patterns to determine when to get in and out of a short.

The first example comes in the form of Figure 13-7 and a chart of First Horizon National (FHN), which is the parent company of First Tennessee Bank and some other financial subsidiaries. Also, for the sake of full disclosure, I used to work for this company, and their stock is the first I ever owned. But I'm talking about Wall Street, here, not Memory Lane, so let me get on with it.

Figure 13-7:

The stochastic indicator and bearish candlestick patterns signal entry and exit points on a chart of FHN.

Figure 13-7:

The stochastic indicator and bearish candlestick patterns signal entry and exit points on a chart of FHN.

The stochastic readings in Figure 13-7 are in overbought territory when the first day of a three inside down candlestick pattern emerges. Coincidentally, the fast stochastic crosses under the slow stochastic as the pattern comes together, and the result is a full-blown short-sell signal.

The resulting downtrend stays in place for a couple of weeks, and the stochastic levels finally reach an oversold level after a long black candle pushes prices down. The following day sees a small rebound, and more importantly, a cross of the fast stochastic over the slow one. That's your exit signal.

Keep in mind that generally speaking, you can forego a revealing candlestick pattern and rely on another technical indicator when picking a spot to exit a trade. Exits are usually a little less precise, and often one technical indicator is enough to go on. It's better to have a candlestick pattern for confirmation, but it isn't absolutely necessary.

ttNG/ You'd need to get out of the short in Figure 13-7 quickly, because the next day gaps higher and the gap isn't filled. Prices just keep moving up, which is pretty scary for a short in this position. Not exiting quickly when a stop loss signal is hit can result in worse losses. Figure 13-7 is a prime example.

Figure 13-8 is a real beaut. This chart is of Vornado Realty Trust (VNO), a real estate investment trust that owns office buildings in the New York City area.

Figure 13-8:

Bearish candlestick patterns and the stochastic indicator provide entry and exit signals on a chart of VNO.

Figure 13-8 is a real beaut. This chart is of Vornado Realty Trust (VNO), a real estate investment trust that owns office buildings in the New York City area.

This chart is another good example because there are three potential actionable signals in a row, each with its own unique characteristics. Working from left to right:

1 The first highlighted candlestick reversal pattern is a doji that occurs after several very strong days in a row that have pushed the fast and slow stochastic readings into the overbought range. The fast stochastic crosses under the slow stochastic on the day after the doji, and that cross confirms the doji and offers a short entry point. The resulting bearish price action is pure happiness for shorts: ten bearish days in a row after the confirmation day. It culminates with both stochastic readings reaching the oversold level.

Then, on the tenth down day, another reversal signal appears! It's a hammer pattern, and given the market environment, it's pretty clear that this hammer indicates that the trend will be heading upward soon. It's time for the shorts to cover and walk away with an appealing profit.

Before I move on to the second sell signal on this chart (the next bullet point), note that the hammer pattern isn't just an exit signal. It can also be used as a buy signal for a long trade! There's nothing wrong with making money on the same stock being both long and short. From personal experience I can tell you it's actually a lot of fun, and can be quite profitable!

1 The second sell signal on the chart in Figure 13-8 is a gravestone doji, and it appears because the stochastic levels are both in overbought territory (details of the gravestone doji in Chapter 5). Much like the first signal, it's followed by a down day that results in a crossing of the fast stochastic under the slow one. That's confirmation that the gravestone doji indeed signaled a trend reversal, and it presents a short entry opportunity.

The second trade doesn't work out quite as well as the first, but if you trade nimbly you may break even at the very worst, and you more than likely will book a small profit if you follow the rules. The entry day is followed by a little bearishness, but the bulls come in and cause the stochastic indicator to show a change in trend to the upside. A quick exit of the short would be in order.

i The third sell signal has a pattern that's a little more elaborate and is a three inside down reversal pattern (covered in Chapter 10). Like the previous two reversal signals (previous two bullets), it occurs with the stochastic indicator in the overbought range, and during the pattern formation the stochastic indicator signals a change in trend to the downside. You guessed it: That serves as a short entry signal.

The exit on this last trade is pretty quick and not terribly profitable. Once again the stochastic indicator changes trend just a few days after the short entry point. Luckily, if followed correctly, a small profit would've been booked.

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