When a share price gaps down, what happens next?
Over the course of the past year (and longer) you will have noticed that we have reported a steady stream of 'price shocks' where the share prices of the companies concerned have 'gapped down' suddenly. These events may give you serious problems, or present you with significant opportunities, depending on your strategy and what happens next.
Let's look at some historic but not-too-distant price shocks to see what happened next.
My Mind the Gap article in February showed how the Lavendon (LSE: LVD) share price had fallen by about 15% in a single day. With the perfect hindsight shown below we can see that the price fell a little more (as it often does), and then offered a potential medium-term 15% recovery profit (if you banked it) before drifting lower and moving sideways.
Either way, buying this stock immediately after the price shock would not have been a disaster. And continuing to hold your existing Lavendon shares, rather than selling out in panic, would have incurred no greater loss than the one you had already suffered.
The moral of this story is that once a price shock has occurred, it's probably too late to sell and it may not be a bad time to buy.
In the same article, I also highlighted the Severfield-Rowen (LSE: SFR) price shock of 27 January 2011.
Perfect hindsight tells the same story as before: while the price will likely go a little lower, once the shock has hit, you have little to lose by keeping holding or even jumping in anew. Or does it?
Before you get too complacent about holding on, or buying afresh, as soon as a price shock has occurred, consider the case of Dixons Retail (LSE: DXNS).
It seems to have exhibited the same behaviour of stabilizing after the initial big 20% fall, but note that the eager beavers who bought in immediately after the initial price drop would have suffered a subsequent 12% fall before the price began to recover and stabilise.
The moral of this story is to enter only cautiously after the big fall, and prepare for things to get worse before they get better.
The recent case of CPP Group (LSE: CPP) also shows us how things can get worse before they -- hopefully -- get better.
While you might have considered it too late to sell immediately after the price shock, you would have been wise to wait a little before jumping in to a brand new position.
Mouchel Group (LSE: MCHL) is what we might call a serial shocker. Having bought at a price of about 77p immediately after the initial price shock, you would have endured a 30% loss en route to a 100% profit, and then would have been back to 'square one' by the end of the chart.
A nimble swing trader could have done well here, but could 'you' hold your nerve on this roller coaster ride?
Let's conclude with the recent case of Desire Petroleum (LSE: DES).
Yes, I got caught out by this one by stopping out at a gapped-down price of 16p, and my non-guaranteed stop order at a much higher price didn't save me. What did save me was my policy of holding very small exploratory position sizes until a share price moves in the direction I want, so I had only a token position in this stock when the price shock occurred.
At the time of writing it's too early to tell what will happen next in any long-term sense, but in the chart it looks like the price has now stabilised. Since the price has not (yet) rebounded upwards I could re-establish my position at my stop-out price, which would be equivalent to having not stopped out at all but having simply 'held'; so no harm done, relatively, by the disadvantageous stop-out.
I could now establish a double position so as to benefit double on the way back up, or I could wait to see if I can establish a new position (or a new double position) at a lower-than-stop-out price of say 10p -- thereby having actually benefited from stopping out at the 'higher' price of 16p.
By the time you read this, the price of Desire Petroleum will have gone one way or the other, and you will have the benefit of the perfect hindsight that I simply don't have as I'm writing.
Future perfect hindsight could even show that it has joined the ranks of the price shockers, like Connaught, which subsequently fell all the way to zero. It's not a prediction, but this mere possibility makes me think carefully about my position size.
More from Tony Loton:
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