What We Look For When Fading Strength

JC Parets
August 29, 2018

Over the last few months we've talked about the diminishing number of short setups as even the weakest sectors and individual names begin to stabilize, however, we're still open to short opportunities. So today I want to discuss what goes into our thought process in distinguishing between stocks that we want to be selling strength in, as opposed to stocks that are stabilizing and not the best candidates to short.

For the purposes of this example we'll talk about two stocks in the Industrial Manufacturing Industry to show that while this is a weak Industry, the individual names to play this theme through are very different.

First let's take a look at Bharat Electronics as a name within this space that we want to be selling.

Click on chart to enlarge view.

This stock has a few important characteristics:

  • Prices didn't retrace back to former support
  • The 200-day moving average is downward sloping
  • Momentum remained in a bearish range during the pullback
  • Our risk is well-defined and reward/risk is skewed in our favor

These characteristics are all indicative of weak stocks and downtrends.

Cummins India on the other hand is a name within the same group that we don't want to be fading.

At first glance this stock looks to be in a very similar position, retesting the breakdown from earlier this year in the presence of a downward sloping 200-day moving average.

There are a number of important differences though.

First off prices reclaimed former support, indicating the supply/demand imbalance previously at that level is no longer valid and that buyers are possibly back in control. Additionally, momentum hit overbought conditions during this counter-trend rally, which also indicates an overwhelming number of buyers.

These are not developments that we want to be taking lightly. Weak stocks do not get back above former support and do not have momentum get into overbought conditions.

Does this no longer being a short candidate automatically make it a long? No. Trends take time to reverse and develop, so this is a situation where we want to be patient and see what happens. The mixed signals from price and momentum continue to suggest there's little edge in the stock.

Whether we're erring on the long or short side of a trade, we want to be involved in stocks where all (or the majority) of evidence that we look at is pointing in one direction. Stocks like Bharat Electronics exhibit the characteristics we like when fading strength in weak areas of the market.

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Thanks for reading and please let us know if you have any questions.

Allstarcharts Team

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