The efficient market hypothesis (EMH) may state that the price of a security reflects all known information at any given time, but in the real world, security prices tend to be much more correlated to the psychology of the masses. Long-term investors exploit these psychological variations through value investing, but shorter-term traders and investors can profit more quickly from simple misunderstandings.
TUTORIAL: 20 Investments To Know

Identifying the Opportunities
There are many different types of misunderstandings that can occur in the marketplace, ranging from misjudged earnings figures to ill-informed press coverage. However, they all share one thing in common: They result from a short-term failure to look behind the scenes. Ultimately, the small drops from these investors can trigger larger sales from technical traders and create great opportunities to buy.

A few common opportunities include:

  • Earnings misses are often the result of deteriorating fundamentals, but they can occasionally be attributed to one-time events. For example, a lawsuit settlement or non-cash derivative liability could hit a company's net income and create scary figures on the surface.
  • Bad press coverage can be either misinformed or biased and lead to an undeserved drop in the price of a security. For example, a short seller may put out a bearish story about a company in order to make a short-term profit without presenting a solid case.
  • Technical drops may lead to lower security prices without fundamental justification. For example, a well-performing company may fail to rebound from an important moving average and drop lower without fundamental justification.
  • Unexplained drops can be caused by a number of different things that do not relate to fundamentals. For example, a hedge fund may be forced to liquidate its positions and cause significant selling pressure on a thinly-traded stock.

Researching the Cause of the Fall
Market-beating returns reward the due diligent investor – there's no way around it. This means that it is often necessary to sort through regulatory filings and conference calls in order to create an investment thesis and explanation for the drop. However, the time spent doing this can be significantly limited by knowing where to look for the information.

Reading Financial Statements
Weak revenue or net income figures can shock the market, even if they can be explained by reading into them. If you see a stock drop sharply due to earnings, take a look at the Management Discussion & Analysis section of its 10-Q or 10-K filing. Specifically, the Results of Operations will detail in plain English the reason for the decline in each line item on the income statement. (For more, see Speed Read SEC Filings For Hot Stock Picks.)

Listening to Conference Calls
Conference calls represent management's opportunity to explain their company's situation to investors. Often, this means detailing why revenue or net income has fallen, even if it isn't immediately apparent in the financial statements. Investors are best off listening to these calls directly, but they can also access transcripts on various websites. (For related reading, see Conference Call Basics.)

Debunking Short Sellers
Short sellers are increasingly acting like investigative journalists. While much of their research is well-informed, investors should be sure to check references and validate any conclusions. Meanwhile, many short-sellers targeting a common industry may cause a temporary discount among even reputable companies in the sector – a great opportunity for savvy investors to get involved.

Group-Think Discounts
Thanks in large part to the advent of exchange-traded funds (ETFs), the market tends to group all stocks in a particular industry into a single trade. For example, a drop in oil prices may lead to a decline across all oil stocks – even those that are hedged against oil prices. Investors can purchase these stocks after any drops and sell them when they return to more appropriate valuations and make great risk-adjusted returns.

Watch the Major Holders
Hedge funds and other large shareholders can have a major impact on stocks – especially those that are thinly traded. Upon any unexplained drops in stock price, investors can look at Form 4 filings and/or compare Schedule 13D and 13G filings from period to period to determine changes in holdings. Combined, these filings can provide key details of insiders or significant holders selling.

Planning and Executing the Trade
While "buy low, sell high" may be the prevailing mantra in finance, buying stock in a company that is falling can be a difficult and scary venture. So, what's the best way to determine the right time to buy and sell these often distressed securities?

TUTORIAL: Technical Analysis

Ultimately, technical analysis has proven to be an invaluable tool for determining entry points. Instead of catching the proverbial falling knife, investors should instead look for small changes in technical indicators signaling a change in momentum. After all, even if investors are acting irrationally, there is no reason for them to stop doing so at any given time!

The best technical indicators include:

  • Moving Average Convergence/Divergence (MACD) is a time-tested technical indicator that is designed to signal a change in trend. Investors should look for a bullish crossover above the median, while also looking for upward slopes in shorter-term moving averages. (For more, see Spotting Trend Reversals With MACD.)
  • Parabolic SAR is another popular technical indicator designed to determine the direction of a stock's momentum and when it has a higher-than-normal probability of switching directions. Investors should look for a dot to appear below the stock price on a chart to signal a turnaround. (For more on this indicator, see Introduction To The Parabolic SAR.)
  • Relative Strength Index (RSI) is a third useful indicator used to determine the beginning and end of key trends by calculating the difference between closing prices. Investors should look for a reading below 30 to indicate that the stock is oversold as well as an upward slope before buying.

While technical analysis is certainly no guarantee of success, combining it with a fundamental thesis helps determine statistically probable turning points for which to buy. Selling, on the other hand, is often best done when the stock recovers from its original decline or trades in-line with its comps.

The Bottom Line
There are many different cases when a stock may drop due to a misunderstanding, ranging from earnings misses to non-fundamental selling by a large shareholder. By learning to identify these key trends, investors can make exceptional risk-adjusted returns. Meanwhile, using technical analysis can help identify optimal entry points without "catching a falling knife," creating a better risk profile. (For related reading, also take a look at Blending Technical And Fundamental Analysis.)

Related Articles
  1. Economics

    Understanding Cost-Volume Profit Analysis

    Business managers use cost-volume profit analysis to gauge the profitability of their company’s products or services.
  2. Fundamental Analysis

    5 Basic Financial Ratios And What They Reveal

    Understanding financial ratios can help investors pick strong stocks and build wealth. Here are five to know.
  3. Chart Advisor

    These 3 ETFs Suggest Commodities Are Headed Lower (COMT,CCX,DBC)

    The charts of these three exchange traded funds suggest that commodities are stuck in a downtrend and it doesn't look like it will reverse any time soon.
  4. Investing Basics

    How to Analyze a Company's Inventory

    Discover how to analyze a company's inventory by understanding different types of inventory and doing a quantitative and qualitative assessment of inventory.
  5. Stock Analysis

    Understanding Chipotle's Financials (CMG)

    Learn about Chipotle Mexican Grill and its financial statements, including metrics such as comparable sales, operating margin and returns.
  6. Investing Basics

    How To Decode A Company’s Earnings Reports

    Earnings reports tell investors how a publicly-traded company is performing, but aren’t always easy to decipher.
  7. Economics

    The Basics Of Business Forecasting

    Whether business forecasts pertain to finances, growth, or raw materials, it’s important to remember that a forecast is little more than an informed guess.
  8. Investing Basics

    Analyzing A Bank's Financial Statement

    Investors should analyze a bank’s interest rate risk and credit risk when analyzing its financial statement.
  9. Investing Basics

    Analyze Cash Flow The Easy Way

    Cash flow statements reveal how a company spends its money and where that money comes from.
  10. Term

    Three Ways to Profit Using Call Options

    A call option gives an investor the right, but not the obligation, to buy a stock at a specific price, known as the strike price.
RELATED FAQS
  1. What is Fibonacci retracement, and where do the ratios that are used come from?

    Fibonacci retracement is a very popular tool among technical traders and is based on the key numbers identified by mathematician ... Read Full Answer >>
  2. What items are considered liquid assets?

    A liquid asset is cash on hand or an asset that can be readily converted to cash. An asset that can readily be converted ... Read Full Answer >>
  3. What is the formula for calculating EBITDA?

    When analyzing financial fitness, corporate accountants and investors alike closely examine a company's financial statements ... Read Full Answer >>
  4. How can working capital affect a company's finances?

    Working capital, or total current assets minus total current liabilities, can affect a company's longer-term investment effectiveness ... Read Full Answer >>
  5. What are working capital costs?

    Working capital costs (WCC) refer to the costs of maintaining daily operations at an organization. These costs take into ... Read Full Answer >>
  6. How do I read and analyze an income statement?

    The income statement, also known as the profit and loss (P&L) statement, is the financial statement that depicts the ... Read Full Answer >>
Hot Definitions
  1. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
  2. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
  3. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
  4. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  5. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  6. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
Trading Center