The Backside of a Trade: When to Go Short
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As day traders, the biggest dilemma we will ever face is our own errors. That is, knowing what not to do, and yet still doing it. Lack of discipline, if you will. Therein lies the importance of finding the backside of a trade before going short.
Most newer traders are impatient. A lot like babies, really. You want what you want, when you want it, and you want it right now! Profits galore! This trade to work!
And when it doesn’t work, frustration sets in. Then doubt. Then fear. And you finally hit rock bottom. No wonder so few make it in this industry.
Meanwhile, veteran traders smile and they smile — because they’ve been there. They know the pain of averaging up, and up, and up, only to be stopped out of a trade the moment it turns. Don’t take our word for it, listen to Professional Trader Nate Michaud’s own advice when you have time.
Guys like Nate are veteran traders for a reason. They learned long ago to stop beating their heads against the same old stubborn walls, thankfully before they went broke.
With discipline as our backdrop, we are setting the tone for the importance of understanding the backside of a short trade. As with any trade, you want to have a plan, a thesis, confirmation of that thesis, and all the necessary components to line up before you risk your hard-earned capital.
Jumping in too early can mean the difference between a profitable day, or a losing month. Heck, it can be the difference between a profitable day, or no longer being able to trade because you’ve blown up your account.
Shorting is risky because your reward is limited but your risk can be limitless. Unlike going long, where your risk is limited, and your reward is limitless.
If that doesn’t make sense, imagine shorting a stock with 100% of your capital at $5. If that stock goes to $10, $20 or more, you’ve lost more than your account had to begin with. That’s when brokers liquidate your positions and call wanting their money back.
Don’t think this can happen? Think again. It only takes one black swan event to change your life for better or worse.
Now, that definitely looks scary, doesn’t it. But the great thing is, when shorting is done properly, it can lead to solid gains in the market. After all, stocks don’t always go up. So, why not capitalize on the opportunities when they fall?
In order to do so, it is imperative that you know what to look for and when to time the entry correctly.
Let’s look at a few high level explanations of what to look for, then we’ll dig in deeper with more examples later.
What is NOT the Backside
Let’s get visual, shall we?
At a minimum, a stock has not entered the back side of a bullish run until it is no longer putting in higher highs and higher lows on at least a 1, 2, 3, or 5 minute chart.
Notice the new highs that are circled and the higher lows that are boxed in this CAN example below:
This doesn’t mean that if you employ a scalping strategy, you can’t take a small short from the new highs back to the new lows — granted you are skillful with such a tactic.
Nonetheless, if you step back and view the big picture, it becomes clear that we are on the front side of the bigger move.
What IS the Backside
Depending on the the type of reversal you’re studying, this can vary to some degree. But, for all intents and purposes, a stock is not on the backside of an intraday run until it has either exhausted its upward momentum in such a way that it cannot move higher, or it begins to put in lower highs and lower lows.
On the back side of this CAN example, we notice the boxed lower highs and the circled lower lows.
Of course, the question is “when can you enter and anticipate these lower lows?”
There are many different ways to indicate this, but we’ve picked 8 of the more common and simpler methods.
8 Criteria for Confirming the Backside Short
1. Climactic Volume and Price Action (Exhaustion Volume)
Sticking with our CAN example above, let’s go back and analyze the price and volume action.
Notice two things on this chart: Effort (volume) and Result (Price). That’s really what we want to pay attention to when it comes to analyzing Volume and Price Action trading.
Using the callouts on the chart, what can we glean?
- As effort increases to push the stock higher, we begin to see upper wicks on the candles at those new highs (circled). Thus we can assume supply is entering the market here.
- For each new push to the highs, we see diminishing result (a correction on lower volume).
What this tells us is that there is distribution going into the upward movement, despite some re-accumulation or short covering occurring at the lows. Overall, this could lead the price increase to eventually stall.
2. Multiple Time Frame Extension
In order to qualify the overextended character of the stock in play, we ought to check other time frames as well. The above examples were taken with a 2 minute chart. For this example, lets examine the 5-minute chart:
As a good rule of thumb, for a stock to be considered “parabolic” you want to see at least 3 large marubozu candles (like you see in the Three White Soldiers pattern) in a row, speeding to new highs on heavy volume.
Judging from the chart above, we have just that.
Not only does the stock go parabolic here, but it reaches the upper bounds of its regression channel for that morning — a good indicator of a potential reversal.
Now we have at least a few criteria met as we begin to anticipate the reversal: overbought conditions with supply increasing on heavy volume; parabolic on multiple time frames; and hitting our regression lines.
3. Waves and Diminishing Force
Without getting too detailed on “wave theory” or indicators and such, suffice it to say that most market moves occur in waves. It is something that anyone with just a quick glance can see on a chart.
Here on the front side of CAN, we see 3 mature waves higher culminating in the “V” at the top and 2 consolidation waves that follow. As traders, it isn’t necessary to draw the lines, or even count the number of waves.
You can do that if you want, but the goal here is to mentally anticipate the “late innings” of the bull run. Being aware of the number of waves up, and the force with which those waves are moving can tell us a lot about where the stock may be going next. Especially if we spot exhaustion.
Bulls can’t run forever.
In the example with CAN, it indicates we are due for a pause at the very least.
4. Daily/Weekly Resistance Levels
Resistance levels on higher time frames can be super important when timing your entries. It doesn’t necessarily mean that these levels will work 100% of the time, but when you have multiple criteria lining up, these key levels become an important part of the recipe.
As we zoom out here on CAN to look at the 1 hour and daily charts, notice the arrows we have drawn around the rectangular “support/resistance” zone.
Looking left on the chart, we notice that prior support areas from over a month ago (indicated by the blue arrows) have now become resistance areas during recent trading sessions (more blue arrows).
In fact, this level lines up with the very top of our intraday chart:
As we are building our thesis for the short trade we want to take, this rejection of a key daily price level only adds to our confidence.
Levels like this can lead to really big gains when trading small cap stocks using the VWAP Boulevard strategy. If you haven’t read about it, be sure to check out our Ultimate Guide when you have more time.
5. Candlestick Pattern Reversal
Now we are getting into the nitty gritty of the of the price action. Candlestick Patterns are extremely useful for “reading” the psychology of the trade.
It is the candlestick patterns that tell us the story behind the action between bulls and bears.
On the 5 – minute chart we showed earlier, we saw three extremely climactic bars. When we spot that, we want to narrow our focus to see if we can find any other confirmation candles on lower time frames.
Here on the 2 – minute chart we see a bearish engulfing candle pattern. This occurs when a bearish candle completely engulfs a bullish candle next to it.
In fact, on just about any lower time frame, the 1 minute, 2 minute, 3 minute, or 5 minute, you’ll like find one of the above candle patterns to confirm the reversal.
Sometimes you might even find a deadly kill candle.
Why is this important? Is this the backside confirmation?
No. It is just one of many confirmations.
However, as this article is covering the question of “how to find the backside,” it if the speculative trader wants to find an “early entry,” this would be the spot.
With diminishing force, three-waves up, daily resistance, and now a bearish reversal candlestick pattern, you could enter the trade on the close of the engulfing candle and risk against the high of the day.
6. MACD Cross
For the MACD indicator, what we want to look for is an extension, a divergence, and a cross.
On the 5 minute chart of CAN, we get all three.
Pay attention first to the light blue line drawn from the top of the first MACD extension down to the second. What this tells us is that we have a divergence with the price of the stock and the force of the trend.
As the force of the trend is putting in a lower high, the price was putting in a higher high. This gives us pause for concern that any further price advances can happen.
In addition, we get a “convergence,” or cross, shortly after CAN puts in a top at the daily resistance levels. The short period (12) moving average crosses the 26 period — a bearish cross.
Both of these act as confirmation that we are topping.
7. Moving Average Cross
In addition to the MACD, moving averages can be a fantastic “change of trend” indicator.
In this 2 minute chart, notice how CAN is riding the blue 20ema for the entirety of the move. Likewise, the red 50sma is trending below the 20.
It isn’t until the top is formed and we have put in a lower low and lower high that we see a bearish cross of the two moving averages. This is the confirmation we need for the reversal.
If you want to try to time the reversal a bit early you might try a 1 minute chart. Just keep in mind that you will find more “noise” and false signals on lower time frames because of the volatility.
As you can see, the 1-minute chart crosses at least once before reaching the top. But if you can combine these lower time frames with each other, it can lead to better pilot entries in anticipation of more confirmation.
Or, you can wait for the higher time frames to form a bearish cross. Many times a stock will bounce back into those resistance levels offering a chance to enter on the brief rallies.
8. Lower Highs, Lower Lows
The last bit of confirmation is quite obvious. Like we mentioned at the beginning. With all the above criteria lining up for your trade. You want to see the stock begin to put in lower lows and lower highs.
Just as we had on the front side of the move, we now have a trend forming on the back side. A good trend will often mind the bounds of a channel, and CAN is no exception here.
We ride the new trend down until it changes on us.
And that is the anatomy of the backside of a short trade. The more “criteria boxes” you can check off, the more successful the trade will likely be.
As with any entry in a security, you want your thesis and trade plan to be supported by evidence. After that, it is a matter of mitigating risk by setting a stop loss if the plan goes awry.
The rest is just trade management. Follow the trend until it changes again!
Other Considerations When Going Short
As with any trade, it is always a good to check what the general market is doing. Are the indexes bullish? bearish? trending sideways?
When you watch for the indexes or other industry names associated with the stock you are trading, you can be more aware of shifting sentiment.
As an example, let’s pull up a few other stocks similar to CAN and see how they were performing on this day.
See any similarities?
Clearly, there were more stocks running in the “blockchain” industry that day. This is what we mean by keeping track of broader-related sentiment, industries, and indexes.
One stock’s movement can often signal a change in the others.
As with any stock, you want to make sure there are enough shares being traded so that you can get in and out with the size you want. As a rule of thumb we don’t recommend trading stocks with liquidity below a million shares traded on the day.
Not only will they move more slowly, but your fill prices will likely be affected negatively.
Keep an eye the float of the stock that you are trading. The lower the float, the more volatile — as a general rule.
Imagine a stock with only 5 million shares available to trade. If those shares are being churned through every 15 minutes, you can imagine that the price will fluctuate considerably.
Compare this to a stock like AAPL, which has billions of shares available to trade. Obviously, AAPL will move much slower.
Time of Day
We talk about this in a great post explaining a strategy called VWAP Boulevard. In that post, we outline how the strategy is “time-centric”.
In other words, if volume is not exponentially climactic before 10am and then drastically diminished afterward, the pattern could be broken. Our trading expert Aiman Almansoori also talks about this in his Reversal Webinar on our YouTube, so be sure to check that out.
While shorts can setup any time of day, there are a few generally accepted “best times” to trade. Those are considered the “reversal hour” around 10:30 – 11am and the 2-3pm “profit taking” time.
As always, backtest your strategy in a simulator to find the best times.
Availability of Shares
Not all securities will be available to your broker for shorting. We call these issues “hard to borrow” stocks. Often, you’ll have to locate shares to trade with your broker and this may cost a fee.
Knowing where to set profit targets will depend on a lot of factors, some of which may include:
- The type of reversal
- The demand behind the stock
- The price action
- The indicator you’re using
- Your desired risk to reward ratio
Ultimately, we want to ride the downward momentum of the stock until the character and trend changes.
Backside Indicators for Download
As of the time of publication, there is one known “backside indicator” that has been coded by scripstotrade.com in an effort to make “spotting the backside” easier.
We have not used the indicator, so be sure to test it out before using real capital.
How to Practice Finding the Backside
It has always been our goal here at TradingSim to build the most realistic learning environment for trading the stock market without real capital.
With over 3-years of tick-by-tick data, you can find more intraday examples to learn the “backside” of a trade than you actually have time for.
And that should be your goal.
Use our built-in scanners to scan for stocks that are going parabolic intraday. Watch them, identify your criteria as outlined above, and make the trades.
Analyze a set of at least 20 trades and determine your profitability. Once you see a winning success rate, take it live.