1) The stock is one of your long-term buys that you are planning to hold for years and years.
2) You are investing with money you can afford to lose.
3) You aren’t just averaging down to avoid dealing with a bad stock selection.
4) You are ready to see the price of the stock continue to fall as you mis-time the bounce and watch the stock fall further.
Unfortunately, I had the opportunity to take advantage of a dead cat bounce a few years ago in Oasis Petroleum (OAS). Please refer to the chart of the stock here as a reference. Now the reason I say, “unfortunately,” is that I had originally bought the stock in the $45 range last September. I had bought into Oasis Petroleum to broaden the types of industries I’m invested in, which had been concentrated in consumer discretionary (restaurants and retail stores). Oasis is an oil producer, mainly focused on the northern US oil boom. I liked Oasis because they have strong 3-5 year projected returns in Value Line and because they were in the energy sector – a sector to which I had little exposure. In hindsight (and maybe a bit of foresight), I should have waited because I was buying into an area that had already had a big run-up in prices and was due for a correction.
Well, anyone delighting at two dollar gasoline knows what happened next, even if he doesn’t follow the stock market. Oil prices collapsed, which caused the price of Oasis Petroleum to fall with the rest of the oil-producing sector of the market. I sat and watched as the stock sank into the $30’s, then looked like it would hold in the high $20’s, then completely collapse into the low teens, finally bottoming out at $11 per share. As it turned out, I timed the dead cat bounce almost perfectly, buying in again at $12 per share and then seeing the stock rally over the next few days. Before I sold out it was trading at around $17 per share, giving me a 42% profit on the new shares I bought, although I still obviously lost money on the entire position since I had lost about $28 per share on the shares I had originally bought. The nice thing, however, is that I only needed to see shares increase to $30 per share to break even instead of going all the way up to $45 again. That’s the advantage of averaging down when it is done for the right reasons.
So how do I have the right reasons for averaging down in this case? The first reason is that I saw Oasis Petroleum as a long-term buy that I plan to hold regardless of price movements as they develop and grow. The second reason is that the entire oil-producing industry fell through the floor, taking both good and bad stocks down with it. It is nothing fundamental about Oasis Petroleum that caused the decline – it is the whole market. It is times like this when an industry is in a free fall that really great buying opportunities emerge. I just picked a really bad point to enter the first time.
The first danger of trying to catch a dead cat bounce is that the stock will often fall further than you thought it would. I had looked at getting into Oasis Petroleum again when it had dropped into the mid-twenties since it appeared to have settled out there. Then came a one-day drop to the $15 range, and on down to $11 per share. If I had a trader’s mentality, I probably would have sold out when the price dropped to $11 – which would have been exactly at the wrong time. Because I have an investor’s mentality, I know that I cannot time the market and cannot get the ideal price most of the time. I just accept the fact that $12 per share is a lot better than $45 per share, even if the stock eventually goes to $6 per share before it finishes its slide. This is why you need to buy stocks you’re interested in for the long-term, since that allows the stock the time to recover and grow.
The second danger is that there could be something fundamentally wrong with a stock that falls through the floor. Some stocks never recover. In this case, because the entire industry was falling and it doesn’t appear that there is anything about Oasis Petroleum’s management or prospects that is causing the issues, that is unlikely. Still, this is why you don’t invest more than you would be willing to lose, no matter how good a deal it appears to be. You also don’t keep averaging down, because at some point you’re in it for pride rather than profit. Every investor takes a loss at times. It is the best investors who know when to give up, dust themselves off, sell a losing position, and look elsewhere. Poor investors sit on losses because they are unwilling to admit they were wrong. They then end up with portfolios full of losers.
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.