Mastering the Art of Knife Catching

This column was originally published on RealMoney on Nov. 17 at 12:11 p.m. EST. It's being republished as a bonus for TheStreet.com readers.

Bottom-fishing attracts a wide following, but catching falling knives requires considerable discipline and a little good luck. More often, plummeting stocks deceive traders into thinking they're jumping into bargains, rather than flaming meteorites. But with preparation and a careful eye, most traders can master this classic market pastime.

Chasing lows is popular sport because growth potential peaks at the start of a new uptrend. So getting in right at a bottom can incur the highest profit for any trade. But this is a dangerous game, so weigh the evidence at your disposal before taking the leap, and once you're in the trade, exercise risk management to ensure a safe exit, if proven wrong.

Bottom entry requires a strong stomach. Negative sentiment infects these turning points, even when your signals are screaming about bull-side reversals.

The real problem here is that cheap stocks are cheap for a reason. Long-term downtrends happen because companies fail to perform over long periods of time. Of course, some of these losers turn into well-publicized turnaround stories, but more likely they're stuck in a hole from which there's no escape.

Consider the millennium bubble stocks that are still trading at $2 or $3, more than five years after they basked in the glory of triple-digit prices. Here are two examples that hit very close to home.

My nephew worked at Lucent Technologies(LU Quote) a few years back and still holds the stock, 96% below his entry price. He thought it would recover like other bear-market issues, but bad products have destroyed this company. Alternatively, I owned Apple Computer(AAPL Quote) during the busting bubble and sold it at $15. We all know what happened next.

The first rule in bottom-fishing is to stand aside until the stock stops making lower lows. This is classic Dow Theory that's ignored repeatedly by traders and investors. A stock printing lower lows is caught in an obvious downtrend. When this stair-stepping pattern finally ends, it may be entering a bottoming phase that will eventually yield a new uptrend.

Next, look for long-term support levels. Toggle to the weekly and monthly chart views and search for lows that are five to 10 years old, or longer. You may be skeptical, but these price levels are still in play and can stop a screaming downtrend dead in its tracks.

Seek out bullish volume divergences when examining stocks you think are basing after long-term declines. Investor interest should appear well in advance of price rising off the low and tackling the resistance levels created by the downtrend. Be patient. Bases take time to form and price rarely presses higher without a series of failed rallies.

What does this bullish divergence look like? Note how On Balance Volume rocketed off its historic low after IPC Holdings(IPCR Quote) bounced last month, following a vertical selloff. In fact, OBV now sits higher than it did when the stock traded 12 points above current levels.

Downtrends generate scarred landscapes of resistance that recovering stocks must overcome to regain their bull status. Every prior low, gap and big down bar can stall a new uptrend and force a pullback to lower levels. This raises a critical time issue if you intend to become a successful bottom picker.

Simply stated, you can't be a short-term trader when you're bottom-fishing. Instead you need to place these positions into accounts that can be left alone for extended periods, so reawakening stocks have the opportunity to heal old damage and take out overhead supply. But this doesn't mean you should toss risk management out the door.

In fact, you face far greater risk buying beaten up stocks near perceived lows than hot stocks near perceived highs. So it's vital that strict price-based stop losses be identified and executed without hesitation when hit.

But use a little common sense. There's no point placing a stop loss two points under an entry if the base support is four points away. You have two choices in this scenario. First put the stop under the base and lower position size until you can handle the loss, if it comes. Second, trade subpatterns that let you take losses much closer to your entry price.

For example, look at the congestion near base resistance on Novell(NOVL Quote). This suggests sellers no longer have the muscle to take down prices and the stock is nearing a breakout. You can place a stop loss just below this smaller pattern so the incurred loss will be minor, if it's triggered.

Beware of big and ugly gaps. These volatile events identify price levels that will take a very long time for stocks to overcome. Always trade the chart without the gap, whenever you have a choice between similar patterns. While risk is nearly identical in both cases, the gap-down chart offers far less reward opportunity over time.

Cypress Biosciences(CYPB Quote) doesn't have much farther to fall, after collapsing to $4.31 last month. But the stock won't see considerably higher prices for months or years, following its 45% gap down. Memorize this brutal pattern and avoid it like the plague the next time you're bottom-fishing.

P.S. from TheStreet.com Editor-in-Chief, Dave Morrow:
It's always been my opinion that it pays to have more -- not fewer -- expert market views and analyses when you're making investing or trading decisions. That's why I recommend you take advantage of our free trial offer to TheStreet.com RealMoney premium Web site, where you'll get in-depth commentary and money-making strategies from over 50 Wall Street pros, including Jim Cramer. Take my advice -- try it now.