Mike’s note: With the action we saw in the market yesterday, I started thinking about an essay Jeff wrote from a while back…

You see, a popular strategy lately has been to buy stocks in free fall, and hope they’ll bounce back in order to turn a quick profit.

While it can occasionally be profitable to “catch a falling knife,” most folks wind up losing money with this strategy. However, the way Jeff approaches “falling knives” is totally different…

Read on to see what I mean. And, if you’re interested in learning more about how Jeff profits on short-term trading setups on a small group of stocks, click here

Most traders are familiar with the cliché Wall Street warning of “don’t catch a falling knife.”

You see, buying into a stock that is falling sharply is generally a bad idea. While picking the bottom of a stock can lead to massive gains… if you buy at the wrong time, it can also lead to big losses. And, frankly, most of the time… that’s what happens.

But there are times when the knife is so close to the ground – where the risk of further loss is minimal, and where the potential gains are so enormous – that it makes sense to reach out and grab it.

Today, I’m going to show you how to find these setups…

Let’s start by looking at an example. Take a look at this chart of Lululemon Athletica (LULU), the sports apparel manufacturer known best for its line of yoga clothes…

Back in December 2013, LULU shares dropped nearly 20% overnight (point 1 on the chart) in reaction to some bad news from the company. Now, it doesn’t matter what the actual news was. The important thing to recognize here is that this was NOT a good time to buy shares of LULU. Bad news is usually NOT a one-time event. There’s almost always a second shoe to drop.

So, if you want to profit from “falling knives,” the first rule to follow is to never buy a stock on the first decline from bad news. There’s usually more trouble to come.

Sure enough, after a brief period of consolidation from mid-December 2013 to mid-January 2014, LULU once again tumbled 20% (point 2 on the chart) in reaction to bad news.

This brings us to our second rule… After the second shoe has dropped, traders can start looking to buy – if the technical condition supports a bottom.

I like to look at the momentum indicator (MACD) to get an idea of where a stock is likely headed next.

The MACD indicator helps to gauge the overall strength of a trend. For example, if a stock is dropping to new lows and the MACD indicator is hitting new lows as well, then the downtrend is strong and likely to continue.

On the other hand, if the stock is dropping to new lows but the MACD indicator is rising, this “positive divergence” is likely an early sign that the trend is ready to reverse.

In the above chart, when LULU dropped to a new low in early February 2014, the MACD indicator also dropped to a new low – confirming the downtrend in the stock.

No matter how attractive the stock might look at this point, traders should avoid the temptation to buy it if the technical condition doesn’t support a bottom. There’s still more room to fall and at least one more shoe to drop.

That’s what happened in June 2014. Once again, LULU announced bad news and the stock fell 15% in one day (point 3).

But notice the different action in the MACD indicator at this point. As LULU was dropping to a new low, the MACD was trending higher. This is the sort of positive divergence that reduces the risk of catching a falling knife.

At this point, we had a stock that had fallen hard three times on bad news. It was trading for half the price it traded at six months earlier. And a key technical indicator was signaling that the trend was ready to reverse. This was a low-risk area for traders to buy.

And just look at what happened next…

As you can see, LULU’s June 2014 low marked the bottom for the stock. But LULU didn’t mount a sustainable rally right away. Instead, the stock chopped around for a few months in a relatively tight trading range. Then it exploded higher. Anybody who caught the falling knife in June 2014 was sitting on around a 75% gain by the following March – just 10 months.

To sum up, if you want to profit from a falling stock – there are two important things to remember:

  1. Never buy a stock on the first decline from bad news.

  2. Only buy a stock when the technical condition of the stock supports a bottom.

If you follow these two rules, you can set yourself up to make big profits with low risk from falling knives.

Best regards and good trading,

Jeff Clark

Reader Mailbag

In today’s mailbag, Everett and Fran share how they’re eager to start trading using Jeff’s services…

Mr. Jeff Clark,

I’m not sure if you’ll ever personally see this email, but I’m a 73-year-old, retired firefighter and I’ve been searching for a way to supplement my and my wife’s income. She has Parkinson’s and is unemployed, so the extra income will certainly help! I’ve been looking for over three years for a way to get involved with stocks and options. There are so many snake oil salesmen out there promising great wealth and get-rich-quick schemes, but it’s
all just a hook to get you to spend more money.

I watched you in a video last week, and I believe you are the real deal, and you come across as an honest person that really does want to see your subscribers be successful. I trust you when you said that in the video. As I said, my wife of 33 years has Parkinson’s and is out of work, but I believe with the programs you’re offering and the guidance you’re promising to provide, that we’ll be in good hands. And yes, we know that there is a risk of losing everything we invest! But we’re ready to take that risk.

We’ve saved up some money and are just waiting for the right opportunity. We think you may be the one. We have had a TD Ameritrade account for about 12 months with a small balance. Today, I moved the saved amount into that account. It takes a few days to show up, but we’re starting to read and study your suggestions. Thank you for being there!

We’re anxious and excited to get started with a conservative approach to increasing our nest egg. Thanks again and may God bless.

– Everett and Fran

Thank you, as always, for your thoughtful comments. We look forward to reading them every day. Keep them coming at [email protected].