Bracketing on Stock Price Fluctuation

I've taken notice of a pattern recently. A price drop of roughly 20% is about the most the market is willing to take until people start to buy that stock again.

How can we take advantage of this pattern to make money?

Buy a stock as it drops. The more it drops, the more you buy. Sounds like a death wish right?

This situation reminds me of a story I've heard about a reporter once asking Einstein how to profit from gambling at a casino. The supposed response was simple: "double your bets when you lose".

Doubling your bets as you lose relies on the principle that a string of losses (or wins) becomes harder to maintain as the streak continues. For example the chances of you getting heads on a flip of a coin is 50%. What are your chances of flipping a coin and it landing on heads for the next five flips? Just over 3%. (Multiple your chances of each flip with each other, or .5 x .5 x .5 x .5 x .5 = .03125 or 3.125%.

If you have the funds to keep doubling your bet as your losing streak continues, you will eventually recoup the losses from each lost bet since you keep doubling your wager. You will eventually win a round, thus getting all your money back, plus whatever the payout is.

Table betting limits in Casinos defeats this exact system. Check out the tables the next time your in Vegas and you'll see min. and max. bets. Sometimes the brackets are small like min. $1, max $10 or large: min. $10 max. $10000. The larger the bracket, the more times you can double your bet during losses before you'll hit the limit. Once you hit that limit, you'll no longer be able to sustain the streak and this is how over time Casino's can guarantee their profit.

Now, take all this and apply it to a stock you enjoy betting on, say Apple (AAPL). As robust of an investment AAPL is, its price is subject to some serious dips. Take a look at Nov. 6 to Nov. 12 period of 2007 for AAPL. That's a 19.8% drop over a week.

With this experiment, lets say that we purchase the same amount you already have invested with each 5% drop in price from your baseline ($191.79 Nov. 6 price in this case). You started with $2500 in AAPL? When it hit 182.20, (i.e. 5% less than 191.79), purchase another $2500. Continue this with every 5% or $9.59 drop in price. By the time it hit bottom you would have purchased another $10K worth of Apple, ending at 153.43. After this AAPL rose back to 169.96 very quickly, then continued to edge upwards somewhat steadily till it hit $200 in late Dec.

As the price of the stock climbs back up, sell the additional stock that you purchased on the way down. At $163.02 sell the stock you bought at $153.43. That's 16 shares you bought for 153.43 ($2454.88), sold at 163.02 ($2608.32). You end up with $153.44 minus your transaction costs. Continue this on the way up. At $172.61 (another $9.59 higher than your previous bracket of $163.02) sell the stock you purchased at 163.02 (2500 / 163.02 = 15 shares) ending up with $143.85 profit. Repeat at 182.2 (14 shares x $9.59) for $134.26 and at 191.79 for another $134.26. By the end of the wild ride you would have seen a gross profit of $565.81. Minus transaction costs of $10 a trade you end up with $485.81. Granted, this isn't a lot of return for the amount invested over the period, which is $485.81 / $10000 or 4.9%. On top of that you need to have a lot of cash sitting around to make this work. You could always get greedy and sell late on the way back up, hoarding profits until the ticker price hits its pre-dip levels, but that has its own downfalls including locking up a lot of cash and increasing your exposure.

An important point to keep in mind: this only works for price drops not directly related to the performance of the underlying stock. I.e. don't expect this pattern of drop and rise to happen on a company that just got rung up on charges of accounting fraud. The difficult thing to say with any drops in the market is how far the price of any certain stock will decline. That's why we purchase on the way down, in brackets, and again, sell on the way up, in similar brackets. Unless your oracle of market wisdom is much better than the rest of the players in the stock market, none of us can predict precisely where the plateaus and troughs on a ticker price will be.