Investment managers and authors Gil Morales and Chris Kacher tell MoneyShow.com how they use the head-and-shoulders pattern to identify short candidates. They also detail their method for using inverse ETFs.

Kate Stalter: Today I’m speaking with Gil Morales and Dr. Chris Kacher of VirtueofSelfishInvesting.com. Last week you hosted a web chat here on MoneyShow.com about shorting stocks.

And, shorting is something that’s obviously a topic that a lot of investors are interested in these days, but a lot of people really don’t know how to go about it in a way that makes sense. So can you sum up your methodology?

Gil Morales: Yeah, well, our methodology differs from most short sellers, who I think come from what you might call the school or the university of “I am smarter than the market.”

We don’t really try and bet on fundamentals, so take a fundamentally based short side position on a stock, based on that rather than paying attention to the trend. So for example, individual, high-profile hedge-fund manager shorting Netflix (NFLX) on the way up are really trying to do so on the basis of some fundamental theme that they think is going to overcome the stock at some time.

But the bottom line is: With shorting, it’s just like going long. You want to go with the trend, and so the only time we go short is during a bear market, and the stocks that we’ll pick on during the bear market are the same exact stocks that we may have, or would have been looking at on the long side during the bull phase of the prior market, just before the market topped and went into a bear phase.

So in essence, your buy list during the bull phase becomes your short-sale target list when the market goes into a bear trend. So that’s basically how we approach it.

We wait for stocks to start to break down and we look for patterns that signal—that’s like head-and-shoulders top, late-stage failed phases, some other more bizarre set ups like Rocket Stocks, which Dr. K has done research on, as well as POD [Punchbowl of Death] formations, which are another type of Rocket Stock formation; you might think of them that way, but that’s basically how we operate.

Kate Stalter: Now, Chris, Gil was just talking a little bit about some of the technicals that you look for. Can you say something about that?

Chris Kacher: Well, a lot of times when a stock has been a leading stock, and it starts to show signs of topping out, it tends to get more volatile, and head-and-shoulders-patterns—a good head and shoulders pattern—that is showing possible topping action is going to be a very strong bearish pattern, because what you’re going to see is more volatility at the top.

It’s almost like there’s a tug-of-war between the bulls and the bears as a stock is topping, and sometimes that traces out into a head and shoulders. The ideal head and shoulders is where the right shoulder is much lower than the left—in other words, a stock has had a serious break to the downside, sometimes in the form of a gap-down.

So you get a head and shoulders that’s kind of lopsided on the right side of the shoulder, and then the stock will sputter around and it will often give an entry point on the short side, and oftentimes a stock is trading under its 50-day by that point.

Gil Morales: Yeah, exactly, so, and you can see a pattern. For example, you look at Netflix forming a head and shoulders before it broke down a couple months ago. You saw Green Mountain Coffee (GMCR) doing the same thing.

There’s been several of these types of patterns; I think even Aruba Networks (ARUN) is another one. Amazon (AMZN) is actually, looks like it’s just starting to break down from a very narrow head-and-shoulders formation that it had formed over recent weeks, so that is definitely the pattern to be looking for.

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Kate Stalter: Let’s talk a little bit then about your methodology with regard to weak market conditions, such as, obviously, what we’ve experienced recently. What do you recommend that investors be doing at this juncture?

Gil Morales: Raising cash. If they’re primarily long-oriented, they can try and play on the short side, and you have to wait for the proper setups to show themselves, rather than trying to be overeager.

In other words, you see the market down big for two or three days and you think you’re going to rush in on the short side. You want to be looking for those patterns to be setting up, and also setting up that optimal short-sale point, so you have to be alert for that. Often that’ll happen during bounces in the market after the breakdown of the peak.

So I think the rally you’ve had the last two days here, I think that could be potentially shortable in some of these patterns like Amazon, Apple (AAPL), Netflix, just down the line here; Salesforce.com (CRM) being another one, Baidu (BIDU) is another one that’s continued to break down from a head-and-shoulders-type top. So I think that’s what investors can do in this environment.

But primarily, I think if you’re not the type of person who can stomach short selling—because it’s very volatile, and it’s very dangerous—then I think you should be in cash during this sort of environment, waiting for the next bull market to set up. Otherwise…

Chris Kacher: Yeah, the alternative is a lot of investors opt to use the market direction model, because now with all the inverse ETFs that exist, when the market goes down, these inverse ETFs go up. So on a sell signal generated by the model, you can buy an inverse ETF, and you can actually profit as the market collapses like it did in August.

The model had a sell signal August 2. That proved to be very profitable. The May flash crash of 2010 was also very profitable. So just because the market’s going down, you don’t have to be losing money or sitting in cash.

But, that said, if you are very a conservative investor, my advice would be to do just that and just sit in cash and wait it out until you get some signal to enter a stock on the long side.

Kate Stalter: Now, you just brought up some of these inverse ETFs, the leveraged ETFs. I know that’s something we had talked about previously. How should investors be using these or viewing these at this juncture? I know that can be another area where people need to be pretty cautious.

Chris Kacher: Right. First of all, there’s 1x, 2x, and 3x ETFs, so the 2x and the 3x ones are referred to as leveraged ETFs, and they’re a double-edged sword.

If you’re in a trending environment, either up or down, leveraged ETFs will actually well outperform their 1x counterpart by more than that factor of two or factor of three.

Now, if you’re in a non-trending environment—in other words, the market’s just going up, down, up, down, and not really in any particular direction—the leveraged ETFs will underperform their 1x counterpart. In other words, they will underperform on a 2x and 3x basis. So knowing that, investors should always be aware and position sides accordingly.

An option is to actually go short. If you want to take the bias out of the equation, you could go short a normal ETF, if you can get the borrow on it, and that will take that bias out.

Kate Stalter: I want to talk a little bit, too, about the long side of equities investing. What kind of watch list candidates are you looking at these days?

Chris Kacher: There’s not really much out there in this market environment. In the last several weeks, there have been a couple names that looked somewhat interesting. I think there was Rackspace (RAX)…it’s still holding up fairly well in this environment, the fundamentals are solid. I think there were a couple of retailers as well.

Gil Morales: Questcor has held up pretty well, actually; Questcor Pharmaceuticals (QCOR). And Biogen (BIIB) is also just building a base here and hasn’t really broken down; it’s holding above the 50-day.

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Kate Stalter: So there are a few, maybe, out there to be watching, but you would not suggest entering into a position in any of these at this time. Would that be correct?

Chris Kacher: Over the last several weeks, there have been a couple names that were buyable. But we always advise that if anyone’s going to buy in this environment—it’s a very choppy, high-risk, volatile environment—that they should position-size smaller than they normally would.

In other words, they could pyramid into a position, so their starter position would be smaller than normal. So if the trade proves false—in other words, if it proves unprofitable—they’re going to lose a lot less because their starting position was smaller, and they probably didn’t even have a chance to buy a second or third follow-up position.

Kate Stalter: Any final words of wisdom for investors trying to navigate these markets? There’s a lot of contradictory advice out there. What do you suggest?

Gil Morales: I would say wait for the window of opportunity to open. Be patient. Don’t try and force things in the market.

If you come in and you buy some stock, and they’re not making you any money, well, the market’s a feedback system, so pay attention to that. If you’re not making any money then back away and wait, and I think patience is what I would counsel here, and just waiting for that window of opportunity to open up.

So you don’t want to lose focus in the sense of, “Oh I’m just going to ignore the market.” You don’t want to be in the market, you don’t want to have any capital committed, but you definitely want to be watching very closely.

As we progress through a difficult period, there will come a time when you’ll see things start to set up—stocks setting up in bases, and things starting to improve. And that’s the time you want to be alert, and when you’re going to commit.

Chris Kacher: Yeah, when the window of opportunity is open, it’s not very often, especially in the last few years. It might be open maybe just two or three, maybe four months out of the year. So in other words, you’re taking positions when as many ducks are in a row, so to speak. And when they’re not all in a row, you just stay out of the market.

I know it’s hard for some investors—when they see the market going straight up for a week or two, they feel like they’re missing out and they want to get in on the action—but just because the market goes straight up for a week or two doesn’t mean that the stocks are set up properly.

A good example would be the Nasdaq, and basically the general market, in October went straight up for about two or three weeks, and a lot of investors felt they were missing out, and started to get in. Since that rush to the upside, the Nasdaq has been completely trendless and volatile, and has been a perfect recipe for losing money in the market, especially on the long side.

I think the short side has had more opportunity where there are certain stocks that are set up very nicely on the short side. So even if the market is up on a particular day, that particular stock will actually show quite a bit of weakness, and someone can lean into a short position and make money in this environment. But outside of that it’s been very, very slim pickings.