An old axiom warns investors not to "catch a falling safe", a reference to the fact that a falling stock is not always a bargain. For every solid company whose stock is experiencing a temporary downturn, another is punished by the market for very good reasons and may not recover. To "buy low and sell high" successfully, it makes sense to find undervalued stocks that are trading for less than they should. The trick for investors is separating a temporary stock pullback from a prolonged - and perhaps irreversible - downturn.

Pullback Vs. Regression
One analytical tool that can help investors identify a pullback is an examination of a stock's pricing trends. It is important to distinguish between a (positive) price pullback, defined as a brief reversal of a prevailing upward tendency, and a (negative) price regression, or overall downward trend. While making the distinction appears to be about as simple as distinguishing mud from water mixed with dirt, the process is actually fairly straightforward.

Take, for example, J.C. Penney (NYSE:JCP) during the winter of 2007. From October 5 of that year, when Penney's closed at $68.71 - its highest level in nearly two months - until November 21, when JCP finished the day's trading session at $40.07 (32 days short of a three-year low), the stock steadily declined. Fundamentally, however, little had changed about the company. And, what happened next? Less than three weeks later, Penney's stock was trading in the mid-40s again. (For more on how this works, read Battered Stocks That Bounce Back.)

Lehman Brothers Holdings (OTC:LEHMQ) presents an entirely different set of circumstances. Once traded on the New York Stock Exchange under the ticker symbol LEH, Lehman Brothers was delisted by that exchange on September 17, 2008 after the firm filed for bankruptcy and was removed from the S&P 500 Index. Unlike J.C. Penney, Lehman's fundamentals had changed. Even before the bankruptcy, it was clear that the 158-year-old lending giant had become too entangled in the subprime mortgage mess than was fiscally prudent and was suffering serious financial repercussions. (Take a look at the factors that caused this market to flare up and burn out by reading The Fuel That Fed The Subprime Meltdown.)

Lehman's subsequent share price free-fall was not a pullback but, rather, a realistic assessment of value - leaving safe catchers vulnerable to getting clobbered.

Technical Analysis
Beyond poking into a company's fundamentals, there are a few other ways of identifying pullbacks and regressions. By attempting to determine what technical traders refer to as support and resistance levels, prudent investors can often find critical entry and exit points for the stocks they're trading. (For background reading, see Support & Resistance Basics.)

In general, a resistance level is a price point at which sellers are believed to overwhelm buyers, preventing a stock from advancing any further. A support level is just the opposite, a price point at which buyers are thought to overwhelm sellers, thus providing a barrier against further decline. Most often, these levels are established by examining a stock's behavior in relation to its Bollinger Bands® or by using the Fibonacci sequence and associated "golden ratio".

Bollinger Bands®
Bollinger Bands®, named for their creator John Bollinger, are a series of three-line graphs. One line represents the stock's 20-day moving average and the other two are the standard deviations above and below it. According to Chebyshev's mathematical theorem, 75% of all future price movements will be confined between the upper and lower bands, so traders often use them to define pricing support (lower band) and resistance (upper band). (The Basics Of Bollinger Bands® goes into Bollinger Band® analysis in greater detail.)

Fibonacci Sequence and the Golden Ratio
Many investors use the Fibonacci sequence and golden ratio in the same manner.

Based on the work of Italian mathematician Leonardo Fibonacci, the Fibonacci sequence consists of an unending series of numbers - each the sum of the prior two terms (1, 1, 2, 3, 5, 8, 13, 21, etc.). Dividing the last number in this sequence by the preceding figure provides the golden ratio, or Phi, which is equal to approximately 1.618.

Thus, support/resistance levels are derived by dividing/multiplying the stock's moving average over a given time frame by 1.618. Sometimes, intermediate ratios, such as 1.500 and 1.382, are used as well.

Figure 1 is a demonstration of Bollinger Bands® and the golden ratio in action, using the aforementioned examples of Lehman Brothers Holdings and J.C. Penney.

Measures J.C. Penney Lehman Brothers Holdings
Close $40.07 (Nov. 20, 2007) $7.79 (Sept. 9, 2008)
20-Day Moving Average $49.58 $14.74
Bollinger Range $38.48 - $66.24 $10.76 - $20.70
Golden Ratio Range $30.64 - $80.23 $9.11 - $23.84
Figure 1

Notice that although Penney's November 20 close was the company's lowest in more than two years, it did not break either the Bollinger or golden ratio support levels. In fact, when the stock briefly dropped below $40 earlier in the day - important to the many who believe that round numbers form psychological support and resistance levels - it promptly rebounded. Such was not the case for Lehman Brothers on September 9, when the stock plummeted past all pre-existing support points to finish the day at $7.79.

Five trading days later, J.C. Penney closed at $44.53, while Lehman Brothers stood at 30 cents per share. (For further detail on Fibonacci analysis, check out Fibonacci And The Golden Ratio.)

Other Methods
Investors may also wish to consider volume in their quest for undervalued stocks, something that can be easily accomplished by using a volume-weighted moving average as a starting point.

Bollinger Bands® and the golden ratio are not the only ways to determine support and resistance levels. Often, observation or intuitive measures work just as well. It's also important to remember that many investors who use analytical tools such as these also base decisions on other factors, including a company's financial characteristics, growth prospects, stock valuation, industry and economic outlook, and other company-specific features or economic trends that may influence stock price.

The Bottom Line
Whatever method one ultimately chooses, it's important to remember that the practice of trading pullbacks is inherently risky, so it is probably wise to institute stops and limits when employing such a strategy.

And be sure to watch for falling safes.

Related Articles
  1. Active Trading Fundamentals

    4 Stocks With Bullish Head and Shoulders Patterns for 2016 (PG, ETR)

    Discover analyses of the top four stocks with bullish head and shoulders patterns forming in 2016, and learn the prices at which they should be considered.
  2. Markets

    Is It Time To Buy Emerging Markets? (EEM)

    The majority of emerging markets are dependent on natural resources, delaying a long-term recovery until commodity markets end historic downtrends.
  3. Chart Advisor

    Uptrending Stocks Dwindle, a Few Remain (EW, WEC, WR)

    The number of uptrending stocks is shrinking, but here a few that remain in uptrends.
  4. Chart Advisor

    Trade Setups Based on Descending Trend Channels (LBTYK, RRC)

    These descending trend channels have provided reliable sell signals in the past, and are giving the signal again.
  5. Investing News

    Is It Time To Sell Technology Stocks? (LNKD, AAPL)

    Technology stocks have taken a drubbing in recent days. Is it time to sell them?
  6. Chart Advisor

    How Are You Trading The Breakdown In Growth Stocks? (VOOG, IWF)

    Based on the charts of these two ETFs, bearish traders will start turning their attention to growth stocks.
  7. Economics

    The History of Stock Exchanges

    Stock exchanges began with countries who sailed east in the 1600s, braving pirates and bad weather to find goods they could trade back home.
  8. Chart Advisor

    Breakout Opportunity Stocks: CPA, GNRC, WWE

    After a period of contracting volatility, watch for breakouts and bigger moves to come in these stocks.
  9. Chart Advisor

    3 Charts That Suggest Now Is The Time To Invest In Real Estate (VNQ, SPG,PSA)

    Real estate assets have some of the strongest uptrends around. We'll take a look at three candidates poised for a move higher.
  10. Economics

    Lehman Brothers: The Largest Bankruptcy Filing Ever

    Lehman Brothers survived several crises, but the collapse of the U.S. housing market brought the company to its knees.
  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 is a derivative?

    A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, ... Read Full Answer >>
  3. What is after-hours trading? Am I able to trade at this time?

    After-hours trading (AHT) refers to the buying and selling of securities on major exchanges outside of specified regular ... Read Full Answer >>
  4. Do penny stocks trade after hours?

    Penny stocks are common shares of public companies that trade at a low price per share. These companies are normally small, ... 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. Tame Panic Selling with the Exhausted Selling Model

    The exhausted selling model is a pricing strategy used to identify and trade based off of the price floor of a security. ... Read Full Answer >>
Hot Definitions
  1. Harry Potter Stock Index

    A collection of stocks from companies related to the "Harry Potter" series franchise. Created by StockPickr, this index seeks ...
  2. Liquidation Margin

    Liquidation margin refers to the value of all of the equity positions in a margin account. If an investor or trader holds ...
  3. Black Swan

    An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult ...
  4. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  5. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
Trading Center