How Many Ways to Get to The Bottom?

When looking to buy a stock making a pronounced downward move, picking a bottom can be risky. If you're impatient or in some other way not careful, you leave yourself vulnerable to breaking one of the cardinal rules of trading, which is to never catch a falling knife.

Still, a rapidly dropping stock has to stop somewhere and begin to reverse. Traders with experience at reading charts will be able to spot reasonable areas at which a falling stock will stop, but unless that stock is headed straight for zero, deciding on the ideal technical area to buy can be tricky. Since no two stocks are exactly alike and one trading session will often have little resemblance to the next, what may have been the proper strategy on one day, or with one particular stock, will quite likely not work the next day or with a different stock.

While you might be confident in the areas that your charts show you, where a stock actually ends up can be anybody's guess, especially when there are multiple areas up and down the chart that make reasonable sense. Here, we'll look at examples of three common chart formations, taking into account both the long and short term trajectories of three different stocks, in order to help us identify sound points of entry in stocks that are moving sharply down. Each example occurred over the course of the last two weeks. Keep in mind, the same strategies can be considered on the upside, while either taking profits on a long position, or entering a position from the short side.

Absolute Gappiness!

Of all the technical chart formations, a gap on the daily chart is among the most powerful because it usually sets off a definitive move in whatever direction the gap occurs. You're most likely to see a gap on the chart when some particularly noteworthy news item that comes out before or after a trading session, such as an earnings report or major industry development, thrusts a stock beyond the previous day's trading range. Momentum will then cause an exaggerated move in the direction of the gap. Whether it appears to float in out of nowhere after a period of mellow consolidation or represents a sudden change of course in a series of wild swings, a gap clearly defines a trend in a stock's direction, even if only on a short-term basis. While gaps are significant in their impact on a stock's direction, they're equally important in helping to spot a reversal when the gap gets revisited from the opposite direction, including helping us spot a bottom.

Let's take a look at how in revisiting a gap that previously set off a 16% upside move to a record high, Goldman Sachs (GS) found a bottom that in turn set off a $20 climb (and still climbing!) over the course of four trading sessions.

GS gapped up on July 21st, 2021 and never looked back for more than three months, by which point it rose approximately $60 to an all-time high above $426 on November 2nd. From there, GS meandered down throughout November, a move that accelerated into December as fears of inflation and a rise in COVID-19 variant cases weighed on the markets. Over the course of what turned out to be a 14% decline from the high, there were several opportunities to buy GS and make profitable trades. But where would the ultimate buy area be that would lead to a more notable reversal?

Locating a bottom can indeed be difficult, but if you're aware of a significant technical area, such as an upcoming gap in the chart, you can be confident in a more likely reversal when you use the gap as your point of entry. As we see with GS in this particular instance, the gap play worked on December 20th and it is currently in the midst of a solid up move, in terms of both time and value, since it started its descent from the top, all of which was set up by GS coming into the gap.

When evaluating the correct way to buy on a gap, the initial inclination should be to let the stock completely fill the gap, meaning that it falls below the high on the day before the gap, and allow for it to drop to some point between that day's high and its close. Even if the stock drops below the close by a small amount, it isn't necessarily a violation of the gap, which is important to remember when planning a stop loss order. In the case of this particular trade, GS got a few cents below the high of the day before the gap before reversing considerably higher. In fact, GS also formed an intraday bottom slightly above its low for the day, which provided an ample opportunity to buy in with a clear stop, before its rally began in earnest.

The Second Day Rule

The action on a gap day can be so exaggerated, that it's likely you won't even find a suitable trade on that day, no matter how enticing certain areas on the chart may be. Massive selling begets massive selling as those stuck in losing positions panic into liquidating before their losses become too severe; so the price decline quickly compounds. Such is the case, it will usually take at least one additional day to shake out enough sellers that you can start looking for buy areas.

Danish Pharmaceutical company Novo Nordisk (NVO) gapped lower on December 17th on an analyst downgrade and proceeded to fall $10 between the open and close, from $116.52 to $106.57. Surely a substantial drop in price of 8.5% over the course of a single trading session will offer up at least an opportunity or two to get long, and, in fact, there was a bit of a pause in that day's decline at around $108, that provided a $2 intraday rally at one point. However, those gains were not sustainable and NVO proceeded to make its way lower, closing near it's $106.52 low by the end of the day.

Whether you had gotten involved with NVO in one way or another on the initial gap day, or simply had it on your radar after noticing its large descent, a wise and patient trader would look to the following day to determine an area at which NVO might reverse. As it turns out, around the $102 price point provided suitable support and included a series of notable patterns of highs and lows, that one could safely wager that NVO would find a bottom there and start to turn up. After gapping lower for a second consecutive day, NVO did in fact find its bottom at $102.09 and proceeded to steadily climb $8 (nearly 8%!) over the next four trading sessions. 

Anything can happen over the course of a trading session, especially during periods of high volatility, meaning a stock can certainly firm up and make a reversal during the first day of a deep-down move. Should that happen, you can surely rationalize adjusting your thinking to make a trade that you would not have originally considered as long as your stop orders are in place just in case you're wrong. However, when you notice a first day sell-off in a particular stock, your initial thought process should be to let that day's hand play out and begin looking for the safer buy on the following day. It's called the Second Day Rule, and in this case NVO followed the rule to a T.

The Classic Overreaction

Peloton (PTON) was a stock market darling during the pandemic because of its revolutionary, interactive home fitness equipment. While most major stocks nosedived to historic lows because of Covid's relentless grip, PTON climbed to an all-time high by early 2021 as one of the vaunted "stay at home" stocks. But PTON fell out of favor with investors when the pandemic showed signs of subsiding, losing almost 80% of its value going into Christmas, capped off by (you guessed it!) a dreaded analyst downgrade.

Despite PTON's struggles, it seemed to have found a bottom at around $36.50, due to a series of healthy bounces from around that price point, starting in mid-December. Based on that action, a buy somewhere a bit above $36.50 seemed reasonable with an easy stop. Yet, if you happened to buy at that price on Thursday, December 23rd, you quite possibly were stopped out (or maybe not; it depends on your risk profile), only to see PTON form up at $35.90 before enjoying an intraday rally of almost $3. 

When your stock breaks through your trade area, be sure to pay attention to exactly how far it violates it by and how it acts once it stops. A quick look at the intraday chart on PTON showed roughly 20 good minutes where the stock seemed to attempt a further decline, but there was enough buy-side action to prop it up from $35.90 for a sizeable gain at least on a day trading basis. If you had been paying attention to this, you had ample opportunity to safely buy PTON at, say, $36.05, for example, with a stop below the $35.90 low, and you would have been rewarded for your tenacity. So, will PTON finally break out of its malaise to close out 2021 and start the New Year on the right foot? The fact that it experienced an overreaction early in the day and never declined later in the day is an encouraging sign that a base may in fact be in place and we can expect further advances as the days go by. Even if PTON is compelled to once again challenge its recent lows, you have a reasonable buy and clear cover if PTON ends up working lower still. 

No form of technical analysis is 100% reliable. Countless factors such as overall market direction and world events can cause a stock to blow right through the areas you cooked up from carefully examining the charts. By the same token, many traders won't buy a stock that is bottoming at all and will wait to buy in only after they've confirmed a defined move up. However, if you're inclined to buy weakness, as traders typically are, even if only for a day trade, being aware of certain technical indicators such as gaps, the second day rule, and overreactions can tip the scale in your favor by providing a reliable basis for making trades. With that said, good luck, and mind the gap!