Case Study #1

Wednesday, March 27, 2008

On March 12, 2008, I discussed MEMC Electronics Materials (WFR) as a possible short-sale. This is what I wrote, and this is the chart I included to illustrate my brief discussion.

“As another potential short-into-a-rally situation, I like MEMC Electronics Materials (WFR) as it stalls up here at what may be the top of a right shoulder. I would consider putting this out as a short here, but should the stock be able to maintain further upside progress on above-average volume, I would quickly cover the position. It could break through the top of this current range at 82.92 and make a marginal new high, but I would cover any close above 80.78 and wait for the stock to set up again”

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To some extent, the stock illustrates how tricky short-selling is, and how the right time to short a stock is often a time when you may be afraid to because it looks like it’s going to go higher and certain financial publications graphically highlight the stock’s chart as being at an optimal buy point. As I like to say, one woman’s cup-with-handle breakout is another woman’s head & shoulders top, and often what looks like an optimal buy point is in fact an optimal short-selling point.

WFR is an excellent example of how you have to keep your head clear and your mind open in order to recognize something that is perhaps not obvious to the crowd. The market is like a multi-faceted gem that you have to hold up to the light and turn over many times in order to fully appreciate its reflective properties – it’s clues and messages. WFR, which perhaps to some appeared to be forming a cup-with-handle type of base, was in fact forming a right shoulder in an overall head and shoulders pattern. Like most right shoulders in an overall head and shoulders topping formation, each successive right shoulder can and often does make a marginal new high. This is what fakes everyone out, because it looks like it wants to break out and go higher.

I admit to being fooled by these same situations, but my studies of short-sale set-ups prove, at least to me, that marginal new highs on successive right shoulders in a potential head & shoulders formation are often the exact points to begin looking at a stock from the short side. And the clues are often there, but you have to be acutely alert to them, or they will drift right on by. Look at what WFR did from the time I first wrote about the stock on March 12, 2008 to the date of this case study, March 27, 2008, on the daily chart I’ve marked up. This is viewed from the perspective of the stock as a buy as it breaks out in flawed fashion.

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This formation is really what I discussed in the book I co-authored, “How to Make Money Selling Stocks Short,” as a “late-stage base-failure” short-sale set-up. Essentially, it is a type of head and shoulders topping formation where the right shoulders are higher up in the pattern than the left shoulder or shoulders. Conversely, in what I would call a “classic” head and shoulders pattern, the right shoulders are lower than the left shoulders. But what you want to call it is a matter of semantics – the fact is this type of short-sale set-up is common, and it works.

First of all, let’s keep in mind that as 2008 rolled around, WFR was working on a three-year price move that took the stock’s price up over nine-fold. This monthly chart shows the extent of its price run.

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This is what the stock looks like on a weekly chart. I’ve marked it up as a type of head and shoulders pattern with the neckline shown. This stock has now busted wide open as it blew through its 50-day moving average on huge volume is probably headed for the 64-65 price area, at which point it could begin to rally to form another right shoulder.

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Keep in mind that this short-sale opportunity occurred after an upside follow-through in the general market, and so one could easily miss it. However, this is often when this type of short-sale opportunity will materialize, when you least expect it. And when more and more of these set-ups begin to present themselves in former leading stocks, the market follow-through can often be in danger of failing itself.

Gil Morales

Chairman

Gil Morales & Company, LLC