Connors Research Traders Journal (Volume 24): Beware of Large One-Day Drops

After a market or stock has had a large one-day sell-off do you ever have the urge to jump in and buy because you’re anticipating a quick reversal?

I know I have. Yet, it was never the holy grail as many people would have us believe. And many of those people who do believe it’s the holy grail, likely bought Facebook (FB) last week. And today they’re learning the reality of buying one-day sell-offs. As a whole, they don’t work.

A number of years ago, we tested this. If a stock had an X% drop in one-day, buy and sell X days later, or sell when it rallies – for example when it crosses above a very short-term moving average. Logically it makes sense. The security is oversold and in many cases very oversold. But as we learned then and as we continue to see today, not all oversold situations offer the same opportunities. One day large pullbacks, especially those that were not preceded by an already oversold condition, showed minimal to no edges.

Our findings are further confirmed in a recent paper published in Computational Economics. Titled Short-Term Price Overreactions: Identification, Testing, Exploitation by Caporale, Gil-Alana, and Plastun published in April 2018 found here, further proves this out.

The three found that not only do most markets not bounce after large one-day moves, many show an “inertia anomaly” equating to under-performance.

Those big down days which often look like juicy buying opportunities are as a whole, dead money. In fact they’re potentially short-term money-losing trades. Yes, some do quickly bounce back but trade enough of these over the past two decades and there’s been little to no edge. You’re better off looking for better trading opportunities elsewhere.

Beware of large one-day drops, especially when they occur out of nowhere like Facebook (FB) did last week. As a whole, you may have a better chance making money actually shorting those stocks for short-term trades, taking advantage of the “inertia anomaly” mentioned in the study, than blindly buying them simply because they’re very oversold.

I hope you enjoyed and learned from this issue of the Connors Research Traders Journal. 

Enjoy your trading! 

Larry Connors

Connors Research, LLC

P.S. My new book Buy the Fear, Sell the Greed – 7 Behavioral Quant Strategies for Traders, is available for download immediately. Click here to buy your copy of Buy the Fear, Sell the Greed today.