The Harder They Fall: Three Beaten-Down Stocks for Traders
There are two main approaches to short-term trading. One relies on an unusual event becoming even more unusual. Another bets on the unusual becoming normal and usual again.
The first approach is broadly defined as momentum trading. Momentum traders tend to rely on what I call an unusual event, such as a surge higher or lower in price action to trigger an entry, and then another unusual event–or an extension of the previous unusual event–to lift (or drop) a market to a level where profits can be taken. Typically, this unusual event is a price breakout, more often than not to new highs or lows–which then must be further exceeded in order to produce trading gains in the short-term.
The second approach goes by a number of names–from swing trading to value trading to mean reversion trading. The second approach also looks for a market to do something unusual–a sizable bounce or drop, an exceptionally long period of advancing or declining trading sessions. But rather than expecting that market to continue to behave unusually, the second approach looks to profit as that usual event subsides and the market returns to its previous, normal behavior.
Examples of the second approach would include looking to sell a breakout to the upside rather than buy it or, as is the case with the three beaten-down stocks in today’s discussion, looking to buy a stock that was down big rather than sell it.
Both short-term trading approaches have their validity. As the saying goes, there is more than one way to skin a cat. But we have found that in the short-term, there is often a superior edge in buying weakness and selling strength, rather than buying strength and selling even greater strength. It is true that there are moments when markets are so bullish (or so bearish, for that matter) that buying strength and selling greater strength (or, on the other hand, selling weakness and covering after still greater weakness). But over the long-term, we have found that the edge goes to those who follow the long-time trading and investing maxim: buy low and sell high.
(It is also interesting to note that many of the most successful breakout trading systems have not been used by short-term traders, at all. But have been the province of long-term, trend traders who use breakouts of different types in order to initiate their longer-term trades. The legendary Turtle Traders were and are an excellent example of traders who used breakout trading systems to enter long-term trading positions.)
With a few qualifications, this maxim of buying low and selling high works very well for short-term traders. What is key are two things: determining the optimal time to buy low, to bet on weakness, and determining when weakness is of the temporary variety and when weakness is potentially more enduring and best left to run its course. While buying low and selling high is a maxim traders can trust, we all have seen weak markets become even weaker. Avoid those “terminal” cases and sticking with those healthy markets that are just having a bout of the sniffles is the most important task for the short-term trader.
To address the second issue first, one straightforward way to determine whether or not a market’s weakness is temporary or enduring is to see if that market is trading below its 200-day moving average.
We have found the 200-day moving average to be an effective line-in-the-sand dividing those stocks that are generally strong from those stocks that are generally weak. If we are looking only to buy temporary weakness–as opposed to terminal weakness–then we are looking for stocks with weakness ABOVE the 200-day moving average.
With regard to the optimal time to buy this weakness, our research has pointed to a number of instances where temporary weakness is both pronounced enough AND overdone enough for short-term traders to bet on a resumption of the market’s previously healthy path. One such instance is when a stock is down 10% or more.
It may seem counterintuitive–heck, it might seem downright crazy–to buy a stock that is down 10% or more. But remember: we are not looking to buy just any stock that is down 10% or more. We are looking for healthy stocks,stocks that are trading above their 200-day moving average, who are experiencing atypical, unusual weakness relative to the way they had been trading.
Our research has revealed that stocks that are down 10% or more–but are still trading above their 200-day moving average–are not only excellent short-term trading opportunities to the long side. But also these down 10% or more stocks outperform stocks that are up 10% or more by a significant margin in one-day, two-day and one-week time frames.
At root, this is because stocks that are up big have already attracted plenty of buyers. The danger for these stocks is that those who bought early will look to sell as late-arrivers bid the price of the shares higher. But stocks that have been beaten down–and the harder they fall the better from this point of view–will attract buyers who often leap at the chance to buy quality stocks on sale (“quality” in this context meaning stocks that are trading above their 200-day moving averages). In the same way that a careful shopper will watch a favorite item in a store, waiting for it to go on sale, careful traders wait for stocks to “come in”, to go on sale themselves, before striking.
Looking at the “Stocks Down 10% or More” indicator at the TradingMarkets Stock Indicators page, there were a number of candidates. But three candidates that stood out all had PowerRatings of 8, making them among the more worthwhile stocks for consideration. They are Graham Corporation
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One simple way to trade these three stocks is to place a limit order 5-8% below the previous day’s low–this is, again, working to ensure that you buy weakness as opposed to strength. After the trade is filled, look to exit the stock when it closes above its 10-day simple moving average.
David Penn is Senior Editor at TradingMarkets.com.