The human brain is an amazing thing, especially when it comes to investing. We seem to be wired to want to buy investments that are falling, catching the proverbial knife and shunning those going up. Why is that? I am don’t know but what I consistently hear for investments going up is “It’s at all-time highs. It can’t go higher. When falling, the rationale is “the falling will have to end sometime and the upside when it eventually ends will be huge.” We apparently seem to think we are capable of picking tops (and bottoms). After more than 15 years, being trained by some of the most successful traders/investors, I can confidently say it rarely happens. Sure, a stopped clock is right 2x a day but getting those instances right does not mean it can be done successfully and consistently over the long haul.
Trying to find the bottom in a stock, because of the potential upside is a great lure and one that appeals to me too. These types of trades/investments I affectionately call dumpster diving. To have any chance of success with dumpster diving, I have found they call for a completely different approach than an investment that is in an uptrend. I thought for this post I would actually walk you through a dumpster dive “trade” that I have made in my own account. In the weekly chart of Fitbit (FIT) below you can see it has done nothing but decline once its IPO hangover begun back in August of 2015, losing almost 90% of its value (peak to trough). We see momentum in the upper pane is currently in the oversold zone but is flattening while price has closed higher (albeit slightly) over the past two weeks. This week we closed with another hammer candlestick which, in a decline, can be indications of a POTENTIAL, short term bottom. Notice the other hammer that occurred back of the end of June last year and marked a tradeable bottom. During those next 12 weeks after the hammer, the price of FIT rose 40%. 40% in 3 months is nothing to sneeze at. But following price further, we see it turned out to only be a temporary bottom (why dumpster diving must be a trade and not a buy and held) and the decline once again continued in earnest. Going into this trade with price well below the (red) 200 day moving average I fully realize the odds this trade will not be “the bottom” so I will be looking to take profits rather than hold this long term.
To optimize entries into any investment, whether it be a dumpster dive or not it is imperative you view the investment on a shorter term time frame and look for triggers and entry setups. For dumpster dives, in an ideal world what I want to see are
1. A bottoming pattern
2. An oversold divergent low in momentum
3. An increase in volume more than 25% greater than the moving average on its breakout from the pattern
Since all of these were present (as you can see in the daily chart of FIT above) I entered the position on Friday of last week. My first target will be the first gap fill where I will likely take at least ½ the position off the table. If the stock wants to run higher after the fill, the upper gap fill would be my final target where I would be closing out the balance of the position. If I am wrong in my interpretation and the market pushes FIT immediately lower (without filling the initial gap), I will be exiting on a close below the prior low (in this case the “head” of inverse head and shoulders pattern).
Because dumpster dives are not high probability of success (price is below the falling 200 day moving average which suggests you stay away), they should be viewed as only a reversion to the mean trade and managed accordingly. I will circle back at the point some point in the future when my position has been closed out to see what can be learned from its outcome.
Wish me luck.
