How to profit from a stock that's plunging

This 6 year old article sums up what happens in bearish market when stock plunges. This thing works only in bearish circumstances. Under normal bull conditions, EP bearish candidates tend to rebound after such major drops, but in bearish market they tend to follow through. Market has tremendous upside bias historically and that is the reason for this.

How to profit from a stock that's plunging

On Wednesday of last week, the shares of four small and medium-sized companies plunged more than 20% in a single day on volume at least seven times greater than average.

In the bull market, traders became accustomed to looking at such moves as buying opportunities, playing for a reversal as the cavalry of growth-fund managers rode in to defend their honor. But this is not a bull market, and for the most part, moves of that magnitude have been a red flag of much worse to come. They have become red meat, to be more specific, for the growing legions of quick-trigger short sellers ready to blast anything that wavers to smithereens.

My research shows that in the past two years, this sort of one-day imbalance very often leads to further declines of a similar magnitude. In other words, once a stock plummets, its likely to plummet again.

From March 2000 through the end of last month, 564 stocks sank by more than 30% in a single day on at least 300,000 shares traded and ended at a price greater than $7, according to research performed for me by Tony Kolton of Logical Information Machines. A day later, the prices on average were unchanged from their final price on the plunge day, but a month later the median stock was down 4%, six months later the median stock was down 23% and 12 months later the median stock was down 51%. Of the 437 stocks that have completed 12 months of trading since their plunge date and are still trading, 76% are down in price. (The results would probably be worse if all the -30% plungers that went out of business and were delisted were included.)

I like to see the stock to sink below its 50-day moving average on this move, said George Fontanills, a Florida trader who likes this sort of set-up for short sales. You are looking for signs of fear, of desperation, of giving up, he says. If you watch a stock during one of these moves with five-minute tick bars during the day, you can just feel how support levels crumble faster and faster as the stock sinks. You can keep following the stock lower until you feel the volume dry up, or decrease to the point that sellers are no longer the dominant force in the move, that they have become less aggressive and reached an equilibrium or accommodation with buyers.

Essentially, the 30% down-move tells the bulls that someone has information that they dont have, and that they should now fear more skeletons in the companys closet.

Heres how Fontanills plays such situations. First, he determines whether the news that caused the plunge has a lasting quality that will cause the company to face a bombardment of bad vibes in the media. A revelation of accounting irregularities, for example, will potentially last longer than just a quarterly earnings disappointment. If the plunge looks to have staying power, Fontanills typically waits a few days or more for a mild rebound, then buys out-of-the-money put options that expire three months to 12 months out. Next, he says, we wait patiently for the stock to do what its destined to do, which is fall apart.

He likes shares of companies about which there is a lot of uncertainty, pulling the stock in both directions. Wild oscillations reflexively create even more uncertainty, often persuading more shareholders holding long positions to panic.