Over the years I have seen a very strong tendency with traders wanting to be short the market at the first signs of any strength after they have just observed major weakness. It feels like yesterday a former trader I worked with was shorting SPY at 76 one or two days after we had put in the March 09 bottom. I remember walking over to his desk and saying “JZ we just had a down move in the market of historic proportions we may continue the uptrend for a little longer”. He shrugged at me and a few hours later hit his daily trading loss limit. I think as traders, and perhaps as humans, we have a tendency to overvalue certain data.

When you see the market drop from 118 to 108 in a few days it is kind of hard to believe that the market could ever be strong again. But the fact is that since the market broke its long term uptrend in early August and began consolidating we have had many more consecutive up closes in the SPY than down. Take a look at the big picture spy chart below and you will see each time we have moved off the bottom of this range we have trended higher at least for a few days.

So common sense would dictate after last Tuesday’s powerful close that we remind traders on the desk that they should be focused on trading the market on the long side as long as the uptrend remained intact. Of course this is easier said than done and most struggled as we moved higher Wednesday and Thursday. When the jobs number came out Friday morning and the market popped we were 10% from Tuesday’s low. This indeed seemed like a spot to me where the risk/reward made sense on the short side. I actually shorted the market that day at 117.50 and again at 117 but lost money as I did not follow good risk management rules.

There is a responsible way to get short a market that has trended higher for a few days in anticipation of a powerful rollover. Look at the intraday chart below. I have labeled four key S/R levels that could be used to establish and then add to a short position in the market. I created this chart the second day after the market bottomed so these particular price levels are no longer relevant but they can be applied to any two day period in the market when you are looking for a short term reversal in trend.

1. This was the afternoon high from Day 1. On Day 2 if you fail to trade above this level you can establish a short position with 25% of our ultimate position size. If this level is breached to the upside traders should quickly cover their positions as the uptrend is certainly still in tact
2. This was the afternoon support from Day 1 and if it is breached can be used as confirmation as a change in short term momentum. A move below this level and you could add another 25% to your position. This level tends to be more important if it also had served as resistance earlier on Day 1
3. This was the morning and midday support from Day 1. Notice that on Day 1 after the market had a small down open it quickly traded above the high from the prior day and then pulled back to this level. A move below this level on Day 2 would have me start to believe a reversal was really taking place but I probably would not add here.  However, after a sharp down move below this level I might short on retracement.
4. This was the Opening low from Day 1. This was the market’s last chance to bounce. I would be aggressively covering my short here if I saw any type of defense at this level. Now over three points from the high on Day 2 and the last chance for pullback buyers to jump in so the risk/reward on a short above this level not so good. BUT if this level gets taken out then there are a lot of longs would want out and I would want to be all in on the short risking 20% of what I had captured on the multi-point down move. This is the trade where the best momentum traders will press their bets on the short side looking for many to panic out causing another dramatic down move.

Notice that on Day 3 above the market did initially fail at point 1 allowing a small short to be established, but the market never breached any of the other points and eventually trended higher for the day. By following these rules you would never have a large short position and would cover any remaining initial short from point 1 when this level broke to the upside.

The outline above can play out in many slightly different ways depending on how the multi-day S/R levels have formed. But the overarching principles are the same which is trend/momentum will not change until key inflection points are breached causing more market participants to feel uncomfortable in their positions and start to exit.

Steven Spencer is a co-founder of SMB Capital and has been trading professionally since 1996. More of his trading and market commentary can be found here.

*live trades discussed in this post took place in T3 Trading Group, LLC a CBSX broker dealer