Why savvy shorts covered their positions Monday morning

Free After-Hours Analysis: 

The S&P 500 surged 1.4% Monday, closing comfortably above 4,700 support as last week’s worries faded from memory.

Financial headlines haven’t changed, but the market is enjoying a bit of relief as Congress makes incremental progress toward avoiding a shutdown. Sometimes, that’s all it takes to cure a bout of selling. As the saying goes, buy the rumor, sell the news. And traders were definitely buying the rumor on Monday.

Time will tell if Monday’s strength proves durable, but often, it only takes removing the selling pressure for the market to regain its footing. We will learn more about the market’s mood on Tuesday, but so far, things look promising. One day doesn’t make a trend, but every trend starts with that first day.

As readers will recall, I put on a short position last week. Fortunately, I was prepared for something like Monday’s bounce. As I wrote last week:

At this point, the pullback deserves the benefit of the doubt. Anyone who shorted Tuesday or Wednesday morning is sitting on small but comfortable profits, and they can lower their stops to their entry points, greatly reducing their risk.

[S]horting a rally is one of the hardest ways to make money in the market, so this only applies to the most adventurous traders, but for the moment, this trade is working and we stick with it. The most important thing is respecting our stops. Just ask anyone who shorted “too high” at 4,400, 4,500, and 4,600. Don’t make the same mistake and pull the plug if the short trade stops working.

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With Monday’s buying erasing all of last week’s selloff, that obviously qualifies as the short trade no longer working. Savvy traders pulled the plug at their entry points. As the saying goes, no harm, no foul. This trade didn’t work, but it didn’t cost us anything. Does anyone complain about getting free lottery tickets, even when they don’t pay off? I sure don’t

As for what happens next, Monday’s decisive bounce off of 4,700 support must be respected. At this point, last week’s step back is over, and the rally is resuming. That’s the only way to trade this. For a nimble trader, the bounce off of 4,700 was buyable. The non-stop, nearly straight-up rally through Monday’s session was paid for by tardy shorts getting squeezed out of their positions. Odds are good we will see more pressure applied to bears over the next few sessions.

And if the selling returns, that’s okay, too. I’m willing to ride the next trade in either direction. Start small, get in early, keep a nearby stop, and only add to a position that’s working.

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