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Bearish Engulfings – Trades on GDX, CAT, YUM

The Bearish engulfing is a candlestick pattern that occurs when a bullish candle is immediately followed by a bearish candle that completely “engulfs” it.  These candle patterns are very nice for short term traders as they typically signal a 2-3 day pullback in a stock.  This pullback can be taken advantage of with an easy stop to control risk.

The image to the right illustrates the look of a bearish engulfing.  Note the bullish nature of the stock before the bearish engulfing candle.  The bearish candle is then represented by a morning gap higher followed by selling throughout the day.  The stock eventually closes below the previous day’s low.
The bearish engulfing price action is typically followed by a pullback in the stock.  The severity of the pullback varies from stock to stock but traders normally can capture 2-3 days worth of gains on short or put option position.  In some cases driven by fundamental news events like earnings, a bearish engulfing can signal a much more significant top and the beginning of a new longer term downtrend.

Yesterday, the market opened a bit higher in the morning and closed slightly lower.  This action helped to create bearish engulfings patterns in many stocks.  In fact, 26 stocks in the S&P 500 exhibited these characteristics.  While bears can use this action to establish downside positions, bulls can also use the price action to reevaluate their gains and look to take profits.

The trade on a bearish engulfing offers a very easy stopping point that can be used to control risk.  If the stock closes above the engulfing day’s high, the trade is compromised and it is time to exit the short or put option position.  Typically this type of stop represents relatively small risk compared to the potential gains achieved on a 2-3 day pullback.

There are 3 engulfing plays that I find interesting in the market today.  All 3 can be played with stops on the engulfing candle’s day high.  The gold miners etf (GDX) may be my favorite as it goes along with my bearish gold thesis.  Caterpillar (CAT) and Yum Brands (YUM) represent stocks that have underperformed the market and are more likely to pullback severely if the market falls.  Below are the 3 charts.  Note that of the 3 stocks, there was only one bearish engulfing that did not work.

 

 

CAT had an engulfing on the last day of June that was followed by a rally. One sign that the engulfing was suspect was the gap up 2 days prior.  A strong gap especially in a stock on a downtrend can signal that the engulfing may just be a bullish trap.  Currently, all three stocks show nice bearish engulfing patterns after a 1 month rally and can be played lower with a stop on the engulfing high.

The Coming Trade on Gold

After months of consolidation in the gold market, a very nice trade setup is happening.  Short gold and long the US dollar.  Historically these two asset classes are negatively correlated meaning that when gold rises, the dollar falls and vice-verse.  While there are many fundamental arguments to a rising dollar and falling gold, the arguments are subjective and irrelevant when it comes to managing trade risk.  Because of the subjectivity, my trade setup is simply a technical one in order to quantify my risk and set realistic price targets.

Below is a chart of the UUP which is an etf for the US dollar.  The dollar hit a high in May/Jun of 2010 .  Understanding that a rising dollar contributed very little to the US economy, the Fed set out to devalue the dollar through is quantitative easing polices.  Currency markets responded by selling the dollar while gold markets watched the price of gold shoot up 40%.   The quantitative easing policies have continued from the fed but the effects on the US dollar and gold are wearing off.  This can easily be seen by the recent rally in the US dollar.

The chart pattern on the UUP is a rather unique but accurate rounding bottom reversal pattern.   Rounding bottom reversals typically reverse slowly and gain momentum before shooting higher.  Currently the dollar is building upside momentum and the tendency would be for a major rally to come.

 

I continue to be a dollar bull…at least for the coming 6-9 months barring any major technical changes.  $22.25 becomes a nice stopping point for the bulls to manage risk while a price target of $24.00 would be rather conservative.   Due to their negative correlation over time, a bullish view on the US dollar would naturally lead to a bearish view on gold.

 

The simplest bearish argument on gold is the fact that a multiple year downtrend was broken earlier this year as seen in the chart above. In the chart below, the retracement of the strong rally is noted.  A 32% retracement occurred at the beginning of 2012 and gold shot higher as many who missed the 2011 rally used the retracement level to pile in. When that buying pressure ran out, gold ultimately failed to set a new high and broke its major up trend.

At present, gold sits back at its 38% retracement level with many signs pointing lower.

  • major uptrend broken – already discussed
  • typically when a 38% retracement acts as support once, it fails to act as support again.
  • when the 38% retracement fails, a move to a 62% retracement is common.
  • after an explosive rally as seen in 2011, a move back to a normalized trend is typical.  (as seen in the blue dotted trendline)

 

 

While gold sits at its 38% retracement, it is consolidating.  This consolidation began in May and is still taking place.  This consolidation is part of the natural movements in stocks where they consolidate then trend.  One way to spot a coming trend or consolidation period is by using the ADX.  After a stock has consolidated, the ADX is typically low.  When the trend phase begins, an upturn will be seen in the ADX.  When a stock has been trending and is ready to consolidate we typically see a downturn in the ADX.  Its important to note that the ADX says nothing about directional movement.  It just assists in recognizing when a stock is ready to move.

 

 

 

At present, the ADX on gold is extremely low.  It has yet to turn higher so the consolidation phase of gold is still in effect.  When the ADX begins to turn higher, a breakout in gold will follow.  With the bullish nature of the dollar and the bearish technical aspects of gold discussed above, I expect to see a breakout to the downside.  Confirmation of that downturn would be a move below 153 on the GLD.  A move above 159 would negate some of the bearish technicals and can therefore be used as a stopping point.

 

 

With GLD sitting at $157.60, setting up a short position ahead of a potential breakdown may be premature but offers very little risk if the trade does not work.  With a stopping point of $159, the risk is $1.40 with a reward potential on a breakdown in excess of $10.00.

 

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