This Trade Targets a Potential 11% Return in 9 Weeks

December 30, 2016
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Last week, home goods retailer Bed Bath & Beyond (NASDAQ: BBBY) was in free fall after releasing a disappointing earnings report. It wasn’t alone, though, as several big-name retailers slid significantly that day, resulting in some technical breakdowns.

A number of indices tracking retail also broke down while the broader market simply marked time. Considering this is still the season when retailers make the lion’s share of their profits for the year, that’s a bad sign.

However, while the underlying fundamentals have taken a turn for the worse, it may be too late to sell Bed Bath & Beyond short.

But there is plenty of opportunity in another retailer: Home Depot (NYSE: HD).

In August, I wrote that shares of the home improvement retailer were ready to break support at $135.50 with a downside target of $120.

Traders who took my advice booked an 11% profit in two and a half months.

I like to circle back to stocks I have covered before. If my style and methods worked in the past, why not continue to apply them? And Home Depot once again looks like it’s ready to fall away from resistance and provide double-digit gains for short sellers.

In the chart below, we see that Home Depot set a series of highs over the past 13 months, creating a zone between $135.50 and $139. Splitting the difference gives us $137.25, which is just a penny above where the stock peaked last week. Put another way, HD stalled at resistance.

Indicators such as on-balance volume and accumulation/distribution have both been falling since the middle of the year and barely moved higher when prices jumped during the post-election rally. These indicators take a slightly different approach, but both add volume when prices move up and subtract it when prices move down, and serve as proxies for supply and demand. Right now, HD exhibits excess supply, which isn’t a good sign.

Momentum readings offer another sign of weakness. For example, the weekly stochastics indicator, which works nicely in trading ranges, shows falling highs and falling lows since the November 2015 peak. The trend in momentum is clearly down, and that suggests prices are more likely to fall from resistance than break through it.

The trend in relative performance is also moving lower, meaning that despite the release of pent-up buying after the election, Home Depot still lags the S&P 500 for the year.

This dovetails with the rotation into the so-called Trump sectors of infrastructure, financials and energy. While retail and other consumer discretionary sectors may have moved to 52-week highs earlier this month, their gains came at a much slower pace than the market’s gains. And with retail showing absolute weakness along with relative weakness, the environment for Home Depot and its peers is not favorable.

In order for HD to issue a sell signal, it needs to move below the rising trendline supporting its rally from the November low. A dip below $134.70 would also break short-term support from late December to the downside. Should that occur, the downside target could reach as far as the November low near $120.

This looks very much like the setup of our previous HD short trade, which bounced at support in the $125.75 area before eventually reaching my $120 target, albeit several weeks after I originally thought it would.

We could see that happen again, so I’ve extended my time frame on this trade by a few weeks. Also, be aware that earnings are scheduled to be reported on Feb. 21. Traders will want to keep an extra close eye on the trade then.

Shorting stocks comes with potentially unlimited losses, so to protect ourselves we’ll set our stop-loss at $139.50, which is just above the top of the 13-month range. Another way traders can lower their risk is by using a “backdoor” strategy rarely discussed in the financial media.

For instance, shorting 100 shares of HD at $134.70 would cost $6,735 on 50% margin. But with this alternative strategy, traders could make a 98% return if shares hit my target, and they’d only be risking $1,265 to do so.

Recommended Trade Setup:

— Sell HD short at $134.70 or below
— Set stop-loss at $139.50
— Set initial price target at $120 for a potential 11% gain in nine weeks

Michael Kahn

Sponsored Link: If you’re interested in learning how it’s done, we’ve put together a six-minute training video you can access here for free.

Source: Profitable Trading



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