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The Key to Selling a Bullish Market – McDermott (MDR)

In a stock market that seemingly rises everyday it is difficult to be overly confident in any downside trades.  That said, history shows us that some of the best bearish opportunities happen when the last of the bears have thrown in the towel and most everyone is bullish.  It takes a lot of courage to sell into a rising market.  If you are wrong, you will be accused of over thinking the market but if you are right and set up the trade properly, the rewards can be significant.  The key to selling into a bullish market is to minimize the risk while maximizing gain potential if you are right and the stock should drop.

 

One opportunity presenting itself this week is with McDermott International (MDR).  MDR is a heavy construction company whose fate is closely tied to the global economy.  While the fundamentals can be and are argued in the analysts communities, the setup for technical traders is strong.  The setup revolves around 3 primary keys:

 

1.  Earnings reaction.  On Aug 6, after the market closed, MDR released a lackluster earnings report.  (seen in the chart below) On the 7th, the stock fell over 6% to a closing low of $11.20.   Closing lows after earnings typically mark a notable support level.  Psychologically, the stock closed at that level because sellers finally exhausted and buyers finally stepped in on a short term basis.  The 11.20 mark held until late August.  On Aug 29, when the $11.20 level was breached for the 1st time since earnings, buyers reacted by bidding the stock up over $11.50.  For technical traders, this action makes the $11.20 level even more important.  Trading below $11.20 increases the odd of further selling while giving bearish traders an easy stopping point if the stock moves back over the $11.20.

 

2.  Support and Resistance from the 50 and 200 day moving averages.  As seen in the chart above, the stock has been trading around its two major moving averages.  The 50 day and 200 day.  A moving average is a simple trend line that averages the closing prices over a specified time period.  They often help to mark major support and resistance levels.  In late June, MDR broke its multi-month downtrend when it pushed above its 50 day moving average.  The rally was quickly met with resistance from the 200 day moving average.  After failing to break above the 200 day moving average resistance level (even during a rising stock market), the stock has now pushed back below the 50 day moving average.  This action lends credence to the bearish argument as the bullish trend that began in June has been broken.

 

3.  Failing Momentum Indicators.  Two popular technical indicators, the RSI and MACD help to show stock momentum.  While the break below the 50 day moving average shows some downside momentum, the RSI and MACD confirm that downside momentum.  In the chart below, note the new low on the RSI after breaking below its multi week support level.  The MACD has also pushed below zero showing bearish momentum.  These confirming indicators are typical signals seen before a major stock drop.

 

 

With MDR, the trade advantage is clearly in the bear’s favor.  That said, a good trade has a point at which one says…”My analysis isn’t working.  Its time to take my money and look for another opportunity. ”  MDR has a very nice stopping point as noted above with the $11.20 price level.  Trading MDR lower with a stop above $11.20 gives about $0.20 risk with much higher reward potential should the stock retest the June lows.

 

Remember, trading stocks lower in a rising market can seem a fool’s errand, but with with proper risk reward setups like MDR, the payoff can be strong.  The key to selling into a bullish market is to minimize the risk while maximizing gain potential and MDR gives that opportunity right now for the bears.

 

 

Trade of the Day – CAT

This morning’s market is set to move slightly lower as European stocks ticked down overnight.  While the move lower is not a market game changer, it does present a day trade opportunity for the bears.  Caterpillar (CAT) may be the best representative of a stock showing signs of a small 2-3% correction.

Lets start by taking a look at the daily candlestick chart of CAT below.  There are several things to note.

  1. The 1st thing to note is the $87-$88 resistance level.  While this level is not a major resistance level in the long term outlook of the stock, it does increase the odds of a short term pullback to come.
  2. The 2nd observation is the strong buying volume seen in the middle of July.  This volume is typical of a declining stock that is putting in a major bottom.  With the potential of a major bottom, we must keep in mind that any bearish trade is short term
  3. During the stock rally over the last 4 days, trading volumes have been on the decline.  Declining volume is a typical sign of a short term pullback to come.

CAT Daily Chart

With short term trading, keying only off the daily chart can be dangerous.  The addition of a short term chart is needed.  My favorite is the 1 hour chart as seen below.  When looking at the hourly chart, there are a few things to keep in mind.

  1. The final hourly candle of the trading day can give a strong clue into the next day’s stock direction.
  2. Closes below the 7 hour moving average are typically bearish while closes above the 7 hour moving average are typically bullish.
  3. Confirmation is needed to play the tendency of observation #2.  This confirmation typically comes in the form of a gap the next day.  A gap lower after a bearish close the previous day can be played lower as in the case of CAT below.
  4. Short term support must be located as well as a stopping point if the trade moves against us.  This short term support is created by the gap higher earlier this month as well as the bottom band on the bollinger bands.

CAT Hourly Chart

The Trade:

  • Short Sell CAT on the open for 87.70-87.90.  In the money options can be used for lower or no margin accounts.
  • Stop out on a move above the 7 hour moving average.  Risk of $0.70-$0.90.
  • Take profit around $85.50 or today’s close.  Reward potential of $2.20-$2.40

This trade setup gives us approximately a 3-1 reward to risk ratio.  When reward is higher than risk at a 3-1 clip we know the trade is a solid setup as long as the technical outlook confirms the trade.

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