Go Go No Mo A shorting strategy for high relative strength stocks By Dave Landry

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1 Synopsis Go Go No Mo A shorting strategy for high relative strength stocks By Dave Landry High relative strength (aka momentum) stocks can have incredible trends, but those trends can often end badly. This is especially true for companies that are one-dimensional or in a business where it is very easy for competition to arise or a fad to go out of style. However, just because the trend often ends badly doesn t mean you can short a stock just because it is at high levels. You re better off waiting for a trend transitional pattern before looking to enter. Defined Relative strength is just that how strong a stock is relative to other stocks. Comparisons can also be made to the overall market. High Relative Strength Usually A Good Thing, But It Often Ends Badly Don t get me wrong, I m a big fan of high relative strength. In fact, a big part of my methodology is built upon finding high RS stocks and looking for a place to get aboard. I then hope to ride out what turns out to be a nice long trend. However, once momentum becomes extreme, especially during less than ideal conditions, it usually ends badly. If market conditions go from bad to worse, high RS stocks can often implode as investors look to exit on their only remaining position(s) that are profitable. Conversely, if mediocre market conditions begin to improve immensely, then high RS stocks can often become a source of funds for value players looking to buy lower priced stocks. Maturity: Reality Sets In-Splitting The Bean, Not The Atom Someday, I m going to get around to building a trading system that incorporates fundamentals. Now before you gasp, hear me out. I think the best momentum stocks are those with the worst fundamentals. These stocks trade purely on emotions because there are no fundamentals. And as long as promise for big future profits stays alive, the stock continues to climb. Therefore, the system would first seek to identify trend, but would also require the stock to have poor fundamentals. Let s call it the Go Go Mo Poor Fundy Strategy. There s some fodder for research. You re welcome. Markets trade on perception, not reality. This perception can make for some wonderful uptrends. Once reality sets in, though, the trend often ends. Green Mountain Coffee (GMCR) is my favorite example. I m not sure what switch got flipped, but somewhere along the way people must have realized that Green Mountain just sells coffee. Good coffee, but just coffee. It s not rocket science. They re splitting the bean, not the atom. Considering the above, for this strategy I like single dimension companies with a fairly low barrier to entry. A restaurant, a video distribution company, and of course, a coffee roaster are examples of

2 companies that might be great at what they do, but competition or a new fad is often just around the bend. The Only Game In Town During Poor Conditions When the market is in a downtrend, the few remaining strong stocks stand out. It s the only game left in town. The pressure s on these stocks. Private investors are happy that at least something is working in their portfolio. Money managers are forced to buy these stocks because they will likely be questioned as to why they don t own these obviously strong stocks. This so called window dressing occurs so that these stocks are on the balance sheet before they do any reporting. The problem is, if a stock has been strong for a long time, it s likely that it has already been window dressed. Further, since the trend is so obvious, many private traders will also own the stock. The question now becomes: Who s left to buy? Who s Left? So who is left? The Johnny Come Latelys, that s who. These are the traders who buy very late in the game. They throw in the towel and buy regardless of the price. They can t stand being left behind any more. The problem is, they are usually the fast money. Money that s late to the game but quick to exit on any signs of adversity. They are the last in and first out. The beginning of the end is often triggered by these fickle traders. When Happiness Ends When a stock makes a new high, everyone who owns the stock prior to that high is happy. They are making money. However, once the stock begins to drop from that high, there are losers in the stock. The more it drops, the more losses are incurred by those holding the stock. Anyone who bought above the current price is now at a loss. The aforementioned Johnny Come Latelys tend to quickly dump the stock. This can often start the cycle down. Those who bought prior to the highs are beginning to feel pressure. Further, those longer-term holders of the stock are beginning to see their profits quickly erode. Selling begets more selling. Let s take a look at this graphically. Referring to the chart below, at point (a) everyone who has ever bought the stock, with the exception of the person who bought at the exact high tick, is at a profit. So, everyone, with the exception of Mr. High Tick, is happy. Now, notice that the stock begins to slide. At point (b), anyone who bought the stock above (b) is now at a loss. Further, pressure is being placed on those who own the stock below (b) the yellow area because they are losing open profits.

3 When a stock in a longer-term uptrend begins to fall, the psychological pressure on the owners of the stock begins to mount. Often, after the initial slide, there is a quick pullback. This can be attributed to bargain hunters buying the stock thinking that it is on sale after all, in this case it is over 20% cheaper than it was just a few short weeks ago. It is also possible that there is some short covering by the shorts that successfully picked a top (which is a bad idea, but I digress). If the pullback fails to materialize into a full blown reversal and the stock begins to sell off again, owners of the stock might look to mitigate their losses/lock in remaining profits. As the stock continues to slide, more and more pressure is placed on those who still own the stock. This is why my favorite trend transitional patterns are those coming off of all-time highs. This helps to ensure that the largest number of players are on the wrong side of the market. Everyone is happy, but that happiness quickly erodes as the stock turns down. Don t Fight It-Wait for Signs Let s say you ve identified an extremely strong single dimension company that s ripe to fall. Should you short it? No. Many of fortunes have been lost doing just that. Trends often go much further than most are willing to believe. One of my favorite sayings is do not confuse the issue with facts ( Wait for signs that the trend may be turning. In other words, wait for what appears to be a trend transition. This means that the market has shown signs of reversing its longer-term trend. You then look to enter on the first correction. Trend transitions

4 are illustrated below. Figure 1: Trend Transitions. Source: The Layman s Guide To Trading Stocks Arrows or Gold? Keep in mind with any transitional pattern* you could end up fighting what is only a correction in a longer-term trend. You re a bit of a pioneer. And like the American Pioneers, you re either going to get the gold or arrows in your back. Since major market turns can occasionally be caught, the chance for the gold makes it all worthwhile. We can t forget about risks though. Therefore, since there is a fairly high likelihood that you could be wrong, proper money management is key. It s beyond the scope of this article to discuss the details. See my books for more information. For now, just know that you must use a protective stop and only risk a small percentage of your trading account. This actually applies to all setups and strategies, not just a somewhat riskier one like the Go Go No Mo. Rules and Guidlines 1. The stock must be extremely strong and have recently made a multi-year or ideally, an alltime high. The stock should ideally be single dimensional, have low barrier to entry, and/or be a fad type of company. 2. The stock should form some sort of transitional pattern. We ll focus on the First Thrust but it could also be any other trend transitional pattern or combination thereof. A First Thrust is formed when a stock makes a new high (1), sells off sharply from that new high (2), then has a brief pullback(3). You then look to enter the stock as the pullback triggers (4).

5 Coming Down The Mountain The aforementioned Green Mountain Coffee (GMCR) fits the mold for a Go Go No Mo candidate. It is single dimensional go go stock that, again, is splitting the bean, not the atom. The stock makes all-time highs(1), but then begins to sell off sharply from those highs(2). It then subsequently pulls back (3). This action sets up the aforementioned First Thrust pattern. It also sets up additional transitional patterns such as a Bow Tie (not shown).

6 The stock triggers an entry (1) and then sells off hard (2) losing over half of its value over the next few weeks.

7 Diamond Foods (DMND), a snack food processor and distributor, provides another great example. They are cracking the nut, not organic molecules. The stock makes all-time highs(1), but then begins to sell off hard (2). It then pulls back(3) to complete the First Thrust pattern. The stock sells off hard over the next few weeks, losing over half of its value. The Latest Victim Since I ve spoken about this pattern at the American Association of Professional Technical Analysts 2011 Brainstorming conference and in my webcasts, I thought I d crank this article out in a few hours. I d just cut and paste a few graphics from my slides, write a few words, and be done. However, it s 3 weeks later and I m just getting around to finishing the article. What s cool is, during this time the market gave us yet another Go Go No Mo. Let s take a look at Chipotle Mexican Grill (CMG). Full disclosure: this stock was in my Landry List (ancillary setup) in my trading service and was a direct recommendation for an institutional client. The trade is still open as of 08/03/12. CMG qualifies as a Go Go No Mo candidate since rolling burritos is not rocket science. The stock makes an all-time high(1). At this point, it appears that they have a monopoly on Mexican food. The stocks sells off fairly hard and then pulls back (2). This completes the First Thrust pattern. The stock triggers an entry (3) and makes a nice quick swing trade move lower, but then trades sideways. The patient traders are eventually rewarded as the stock implodes, losing over 100 points in a few days.

8 Summary High relative strength stocks can make great buy side candidates, but eventually reality will set in. This is especially true for especially true for single dimensional companies with a low barrier to entry. You can t fight the trend though. Wait for signs that the trend may be turning. Although risky, shorting high relative strength stocks on transitional patterns can create some wonderful opportunities. References *For more on trading trend transitions see Bowties (The Layman s Guide To Trading Stocks), Reversal Gap Strategy (Dave Landry s 10 Best Strategies & Patterns), Gatekeeper (10 Best), First Kiss After Daylight (Layman s), First Thrust (Dave Landry On Swing Trading, 10 Best, Layman s) ebooks for Dave Landry On Swing Trading and Dave Landry s 10 Best Patterns & Strategies can be found here: The Layman s Guide To Trading Stocks can be purchased through Amazon.com. Use this link:

9 To those in countries where Amazon is not available, the book can be purchased with discounted shipping directly from the publisher via this link: