Why Great Stocks Drop Hard and Reverse

07/17/2013 6:00 am EST

Focus: STOCKS

How many times have you seen a good company with strong fundamentals and a seemingly great looking chart break down over one-two weeks and take everyone out of the trade, asks David Banister of ActiveTradingPartners.com, then reverses right back up all the way back to where the decline began?

One thing that will always over rule charts and technical analysis is fundamentals in the long run. To be sure, I love technical analysis but I always combine my work there with fundamental research. I rarely if ever buy a stock just because the chart looks nice, that is almost always a recipe for disaster.

With that said, how many times have you seen a good company with strong fundamentals and a seemingly great looking chart break down over one-two weeks and take everyone out of the trade? Then for sure, the stock reverses right back up all the way back to where the decline began? To make matters worse, this happens without any real news or any bad news as it were. What is it that causes these crazy down the mountain and up the mountain moves anyways?

Institutional sell programs-sometimes referred to as "bots" or "algo" program trading.

How does it work?

In an apparently strong fundamental growth stock with no apparent issues, an institution will have a pre-defined price at which point instructions are triggered to liquidate the entire position almost at any price once that price point is hit. They protect themselves ahead of time with puts, which give them profits if the targeted stock drops hard while they are selling out of the position, thereby locking in their targeted sell price.

Let's take several examples below with three-month charts to show you exactly how they look on paper. If you can learn to spot these moves, you will be more likely to add to positions on big declines rather than selling out at a loss as all the stops trigger along with the margin calls:

The stocks we will chart out here are AMBA, DATA, DECK, and GILD. All strong companies with good growth profiles:

chart
Click to Enlarge

chart
Click to Enlarge

chart
Click to Enlarge

chart
Click to Enlarge

So what have we learned? In a bull cycle, buy the dips on the stronger fundamental stories when the algo and institutional programs start kicking in. Don't panic out of your position at a loss, study the fundamentals, and trust your instinct.

By David Banister, Founder & Chief Strategist, ActiveTradingPartners.com

Related Articles on STOCKS