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. Technical Indicators

    Using Pivot Points For Predictions

    Learn one of the most common methods of finding support and resistance levels.
  2. Active Trading

    An Introduction To Depreciation

    Companies make choices and assumptions in calculating depreciation, and you need to know how these affect the bottom line.
  3. Chart Advisor

    ChartAdvisor for November 20 2015

    Weekly technical summary of the major U.S. indexes.
  4. Chart Advisor

    Is This The Beginning Of A Downtrend In Home Builders?

    Falling lumber prices and weakness on the charts of home builders suggest that the next leg of the trend could be downward.
  5. Chart Advisor

    Is Now the Time to Buy Lumber?

    News that Weyerhaeuser is planning to buy Plum Creek has put attention on the forest-products sector. Is now the time to buy?
  6. Markets

    Operating Cash Flow: Better Than Net Income?

    Differences between accrual accounting and cash flows show why net income is easier to manipulate.
  7. Options & Futures

    Terrorism's Effects on Wall Street

    Terrorist activity tends to have a negative impact on the markets, but just how much? Find out how to take cover.
  8. Investing Basics

    How To Efficiently Read An Annual Report

    Annual reports are clearly prepared without any intent to deceive or mislead investors. Still, investors should read them with a dose of skepticism.
  9. Investing Basics

    Explaining Financial Statement Analysis

    Financial statement analysis is the process of reviewing a company’s statements to gain an understanding of its financial health.
  10. Investing Basics

    How Financial Statements Are Manipulated

    Financial statement manipulation is an ongoing problem, and investors who buy stocks or bonds should be aware of its signs and implications.
  1. 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 >>
  2. 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 >>
  3. 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 >>
  4. How do mutual funds split?

    Mutual funds split in the same way that individual stocks split, but less often. Like a stock split, mutual fund splits do ... Read Full Answer >>
  5. What are some of the most common technical indicators that back up Doji patterns?

    The doji candlestick is important enough that Steve Nison devotes an entire chapter to it in his definitive work on candlestick ... Read Full Answer >>
  6. Who actually declares a dividend?

    It is a company's board of directors who actually declares a dividend. The declaration date is the first of four important ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  2. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
  3. Black Monday

    October 19, 1987, when the Dow Jones Industrial Average (DJIA) lost almost 22% in a single day. That event marked the beginning ...
  4. Monetary Policy

    Monetary policy is the actions of a central bank, currency board or other regulatory committee that determine the size and ...
  5. Indemnity

    Indemnity is compensation for damages or loss. Indemnity in the legal sense may also refer to an exemption from liability ...
  6. Discount Bond

    A bond that is issued for less than its par (or face) value, or a bond currently trading for less than its par value in the ...
Trading Center