Big Pullbacks = Big Payoffs

The harder a stock falls, the bigger the bounce? After looking at millions of simulated trades, that is just what our research revealed.

There are few things harder for the average trader to do than to step up and buy a stock that has been down. It is even harder when that stock has been hit to the tune of 10% or more. After all, a stock that is down 10% could continue to drop to being down 15%, right? Or 20%. Or 50%. The stock could even fall to zero for all we know.

That is why it is so important to have quantified analysis in hand when trading. While it may seem commonsensical for a stock that is down to continue moving lower--and while many stocks do in fact do just that--we found out that when strong stocks experience the kind of aggressive selling that takes them down 10% or more, these are the stocks that will tend to outperform the average stock over the next one-day, two-day and one-week timeframes.

Importantly, by "strong stocks" we are referring to stocks that are trading above their 200-day moving average. There are a number of different moving averages that traders rely on for a number of different reasons. But when it comes to separating the stocks that are more likely to move higher in the short-term from those that are less likely to move higher in the short-term, the 200-day moving average is a valuable discriminator. Above the 200-day, we consider buying and only buying in the short term. Below the 200-day, as far as the short-term is concerned, we are only interested in wagering against the stocks we find there.

Writing about "Large Moves" in his book, How Markets Really Work, Larry Connors made the astonishing discovery that large price declines actually outperformed large price advances by more than 2 to 1 in two-day and one-week periods. When the decline was even more pronounced--for example comparing the difference between 1% declines in the stock market and 2% declines--the gains were all the greater. It was this research into sizable price moves in the broader market that led to his research into the effect of large moves on individual stocks.

Click here to read more about our research into stocks that are down--or up--by 10% or more.

Some of the best times to look for stocks that are down big are when the broader markets are testing significant lows. At these times, trader fear and dread is often at its peak and stocks are at their most vulnerable to irrational and panic-based selling. Good stocks and bad stocks are increasingly sold as the markets move lower and lower and traders brace for the inevitable breakdown. The trader's maxim, "when they're cryin' you should be buyin'" comes from moments like these, when the pain of losses past make traders all the more fearful of the potential for losses in the future. Very often, this fear is overdone, leading to opportunities in stocks that have been sold far too aggressively.

Each of the following four stocks has a PowerRating of 8, and is down 10% or more from recent highs. I have also listed the 2-period RSI for each stock to help traders get a better sense of just how oversold these stocks are. Our 2-period RSI considers a strong stock attractive in the short term when its RSI value drops below 2.

Adolor Corporation (ADLR | Quote | Chart | News | PowerRating). RSI(2): 16.05

Nic, Inc. (EGOV | Quote | Chart | News | PowerRating). RSI(2): 9.49

EHealth, Inc. (EHTH | Quote | Chart | News | PowerRating). RSI(2): 2.99

Intuitive Surgical, Inc. (ISRG | Quote | Chart | News | PowerRating). RSI(2): 8.57

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