Saturday, September 4, 2010

Short, hedge or take profits?

At this point the markets are very short term overbought. With the McClellan Oscillator sitting near +200 the odds of at least a short term pullback with in the the next two to three days is very high. So persons who took long positions 3 - 4 days ago are faced with a good dilemma!

With the widespread push up in the markets over the past three days on good volume, with major resistance in the indexes still some ways higher, the T2108 still below 80 and many stocks breaking out of well formed bases on volume; my expectation for follow through to the upside is high but in terms of a pullback that violates major support, my expectation is low.

I know from past experience that many persons would be inclined to sell their entire position at this point. However, I say NO!. One should be looking to either take partial profits with the intention of adding back on the next pause, hedge long positions with options, prepare to hold your positions through a possible pullback that does not violate the uptrend in the individual positions or put on short swing positions.

I want to explore the last option; shorting stocks. I know it may seem like suicide to short stocks here but that was also the case a week ago when I was recommending getting long stock! Besides by confining shorts to the weakest stocks such as those on my "short watch list" on the right side of this blog the odds of losing money are further reduced. The important thing is to understand that expectation for follow through in these short positions would be low. This has implication for position size and trade management.

Firstly, one should not get to aggressive with per trade risk, the cumulative risk exposure or total number of short positions and profit taking strategy. In terms of profit taking, I would recommend taking 75% of the short position off at 3X risk to lock in 2.25 R profits while leaving the initial stop loss in place on the remainder of the positions. This will ensure that the worst case is a profit of 2R (this was explained in an earlier post). However, it will also ensure that in the unlikely event that the markets break down hard one still has some exposure to the downside and not be on the sidelines beating your self up!

In most instances if not all, it impossible to predict how far and how long the markets or individual stocks will run in a particular direction. For this reason it is important that we let rules based on probabilities guide us. Rules we can repeat consistently, predictions we can not!

Hope this post helps you make some money in this choppy market.

Good luck and good trading!

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