'Dumpers'-- Making Money on a Bad Story

Most traders act like they're in high school. But instead of pursuing the opposite sex, they pursue money -- at least during trading hours. Let me tell you a story to illustrate my point.

I was a moderately popular sophomore (way back when), when WHAM! I got the hottest girl in school to go out with me. Then everyone was my friend. Unfortunately, she dumped me weeks later after she saw how I danced -- and instantly so did all my new so-called friends. My "real" friends came back a week or so later, after my bad news had worn off. I was a dumper.

The same story holds true for "dumper" stocks.

Last week, I told you that the key to high-percentage trading is recognizing patterns in the way investors trade.

Today, I'll discuss one such pattern, dumpers, which are stocks that dump more than 20% in one day (from the previous day's close) on mediocre bad news. I stay away from very bad news dumpers, those with news that would cause a stock to delist, such as fraud, investigations or bankruptcies. (In high school, that would have been like getting VD.) A good example of a predictable dumper would be a company that reports (after the closing bell) it missed earnings by a few pennies.

The Street always overreacts to bad news. I play the bounce once the panic sellers are gone and the Street digests the news, determining that the news is not really that bad. The pattern I play is when the stock gaps down, sells off immediately and then bounces. I watch to ensure that it hits one clearly definable bottom, and jump in just as the momentum is starting. I immediately put a sell order on the screen and wait for the first sign of weakness, which is where I sell.

Cell Pathways (CLPA Quote) dumped on Feb. 22 in reaction to a Forbes magazine story that the company's lead drug, a cancer-prevention compound called Aptosyn, may be denied Food and Drug Administration approval. The company claimed this was false information provided by someone trying to drive down the stock price. The stock closed at 57 1/4 on Feb. 18, gapped down and opened at 50 1/8 on Feb. 22, then immediately sold off to 42 1/2. Note the predictable bounce from the low to 50.

A good trader has rules he follows each and every time without exception. When I play this particular pattern, I have several rules that I follow.

First, the dump must be greater than 20%. I have found that stocks that dump more than 20% have more bounce built into them.

Second, I will only play a dumper if it has 3/4 to 1 point of upside potential built into it. I will explain how I figure the upside and downside potential in the next article.

Third, I will not play low-volume stocks (less than 75,000 to 100,000 shares in the first 30 minutes), nor stocks with more than a 1/4-point spread. Heavy volume stocks indicate a good level of interest by other traders and tend to lead to larger swings and larger profit potential. Low-volume stocks generally have high spreads and move extremely fast on low volume. What goes up fast will go down faster, leaving you holding the bag. If you are on the wrong side of a low-volume trade, your losses can be excessive. Stocks with large spreads have built-in losses. A stock with a bid of 22 and ask of 22 1/2 has a built-in loss of 1/2 point.

Conestoga Enterprises (CENI Quote) is a good example of a low-volume stock (30-day average volume is 7,000 shares). Note the jump from 20 1/2 to 24 with just a few shares traded in the final moments on Feb. 18. This was one to avoid.

Finally, I must be confident that this dumper pattern is currently repeating. I do this by tracking and keeping a daily log of each and every pattern I play. If a pattern is not repeating, I will not play it until my tracking shows that it is.

All of these rules are important to me, because I am looking for a specific pattern that is repeating and predictable. I am not looking for just any stock that is dumping, I am looking for an "old friend" that I can recognize and that I feel comfortable will react in a predictable manner, time after time.

The trick is to find dumpers early, just prior to their first low. I scan for dumpers before the open by watching CNBC for volatile stories and by using scanning software that scans for gaps from the previous day's close. The software gives me a list like the one below.

I use several different news-scanning services that alert me to negative stories by using filters for keywords such as "below," "earnings," "missed," "downgraded," etc.

Once I have my list of potential dumpers, I put them up on the screen and wait for the opening bell. As these stocks start to dump, I look at the spread, volume and percentages they dump, eliminating those that don't meet the criteria. Once they dump more than 20%, I concentrate on these stocks, looking for the first bottom, then jump on just as the momentum takes off. I immediately put a sell order on my screen and wait for the first sign of weakness, at which point I exit and move on to the next trade.

Finding and recognizing dumper patterns does nothing for me unless I can determine a good entry point. The bedrock of my trading success has been my ability to call intraday bottoms and tops of stocks. Over the years I have perfected a very simple but effective technique I call the pause-in-between buying method.

The normal action I would expect from a dumper at the open is a selldown from the open price. I watch the rhythm of the bid and ask as it changes, and ignore the trades at first.

The first indicator of a bottom is a pause in the rhythm of the downticking bid and ask. At that point, I focus on the trades as much as possible, ignoring any out-of-bounds trades (trades that occur at the price below or above the bid and ask).

After I notice the pause, I look for trades in-between the bid and ask. If a dumper has sold down to a 9 1/8 bid by a 9 1/4 ask, I will look for a trade at 9 3/16. This "in-betweener" is the second indication of a bottom.

Below is an example of a time sales chart which shows VISX (VISX Quote) with a bid of 16 1/2 and an ask of 16 9/16. Note the in-betweener of 16 17/32.

I now look for buying to pick up in momentum, and when it does it signals my bottom call. Calling the tops is much the same as calling bottoms, except everything is reversed.

Simple, yet effective. It's worth its weight in gold, but it takes practice, patience and time to learn. Qualities I wish I had in high school. Thank goodness we've all matured since then. Right?

Next week, I'll talk about my secrets for staying the night without getting caught -- i.e., how I calculate a stock's upside potential and play end-of-day dumpers (playing the gap).