Jeff Cooper's Guide to Shorting Stocks with the 5-Day Momentum Method

Jeff Cooper's Guide to Shorting Stocks with the 5-Day Momentum Method

Profiting from a falling market is a skill that separates the versatile trader from the one-dimensional bull. Jeff Cooper’s 5-Day Momentum Method is not just a tool for buying pullbacks in uptrends; it is an equally potent strategy for shorting bounces in downtrends. The principles are symmetrical, but the execution requires a specific mindset and a keen understanding of the rules for bearish setups. By mastering the short side of the market, a trader can find opportunities regardless of the overall market direction.

The Anatomy of a Short Setup

The logic behind a short setup is the mirror image of a long setup. A stock in a effective downtrend will experience brief, counter-trend rallies. These bounces are often fueled by short-sellers taking profits or by bargain hunters mistakenly believing the stock is “cheap.” These rallies provide a low-risk opportunity for disciplined traders to initiate new short positions in alignment with the dominant, downward trend.

The Rules for a Short Setup:

1. ADX Confirmation: The stock’s 14-day ADX must be 35 or higher. This confirms that the stock is in a strong, established trend. A high ADX reading in a downtrend signifies persistent and effective selling pressure.
2. Directional Confirmation: The Negative Directional Indicator (-DI) must be greater than the Positive Directional Indicator (+DI). This confirms that the trend is, in fact, down.
3. Stochastic Signal: The 8-period Fast %K must rise to 60 or higher. This indicates that the stock has become overbought during its counter-trend bounce. It is a sign that the rally is likely exhausted and the primary downtrend is ready to resume.

Executing and Managing the Short Trade

Once the three conditions for a short setup are met, the trade is executed with the same mechanical precision as a long trade.

• Entry: Place a sell short stop order one tick below the low of the day the signal was triggered (the “signal day”).
• Initial Stop-Loss: Place a protective buy stop order one tick above the high of the signal day. This defines the maximum risk on the trade.
• Position Sizing: The position size is calculated based on the trader’s account size and risk tolerance, typically risking no more than 1-2% of total capital on the trade.

Example: A Short Trade in SPY

Imagine the SPDR S&P 500 ETF (SPY) has been in a confirmed downtrend for several weeks, with its ADX reading at 40 and the -DI well above the +DI. After a sharp decline to $420, SPY stages a two-day rally to $430. On the second day of the rally, the 8-period Fast %K hits 65. This is the signal.

• Signal Day Low: $428
• Signal Day High: $430.50
• Entry Order: Sell short at $427.99.
• Stop-Loss Order: Buy to cover at $430.51.

If the order is filled the next day, the trader is short SPY, anticipating a continuation of the downtrend. The trade is then managed using either the 5-Day Exit (covering the short on the close of the fifth day) or the Trailing Stop Exit (trailing a stop above the previous day’s high to capture a larger move).

Special Considerations for Shorting

While the rules are symmetrical, there are a few practical considerations that are unique to shorting:

• Stock Locates: Before shorting a stock, a trader’s broker must be able to locate shares to borrow. For highly liquid stocks and ETFs like SPY, this is rarely an issue. For less liquid or heavily shorted stocks, it can sometimes be difficult or impossible to borrow shares.
• Uptick Rule: While the classic uptick rule was eliminated, some brokers may have their own restrictions on shorting. It is important to understand your broker’s specific rules.
• Market Psychology: Bear markets tend to be more volatile and faster-moving than bull markets. Fear is a more effective emotion than greed, and declines are often sharper and more sudden than rallies. This can work in the short-seller’s favor, but it also requires a steady hand and a strict adherence to stop-losses.

By incorporating short-selling into their arsenal, traders can access a whole new set of opportunities. Jeff Cooper’s 5-Day Momentum Method provides a robust and disciplined framework for identifying and profiting from these bearish setups. With practice and a commitment to the rules, a trader can learn to navigate both sides of the market with confidence and precision.