Bad news can send stocks sharply lower, and that initial down move based on the news is often just the first step in a steeper decline. But unless the company is destined for bankruptcy, the stock will eventually stop falling and turn up. That's the idea behind bottom fishing.
There are some trading strategies that can be used to spot when the selling has gone too far and an upward bounce should be expected. But keep in mind that bottom fishing should only be done in a bull market when stocks have a stronger tendency to rise.
The first step is to identify when the selling may have peaked. In a downtrend, it is very common to see the selling pressure accelerate. As prices fall, more and more traders want to sell and the result is a fast down move. When the selling stops, we often see prices bounce higher, and this is a good time to buy if we can find rules that define this pattern.
To find stocks that have been subjected to rapid short-term selling, we can use a new 13-week low. When prices set a new 13-week low, we can be certain that there are more sellers than buyers.
If we then wait until prices start moving higher, we could be entering a trade after the selling has subsided. Confirming this signal with a buy on the stochastics indicator  should decrease the risk on these trades even more.
Backtesting on the stocks in the Nasdaq 100 index shows that this strategy would have been profitable since the 2009 low with about 70% of the trades being winners, and the average winner would have provided a 16% gain. Trades are closed three months after they are opened. The average annualized gain on this strategy is 28.9%.
One stock that meets those criteria now is GSE Holdings (NYSE: GSE), a company that makes "geosynthetic lining products for environmental protection and confinement applications worldwide." One of the best parts about trading with systems rules is that there is no need to understand what the company actually does, but it never hurts to look at the basic fundamentals.
Revenue from GSE's products totaled more than $490 million in the past 12 months. The company reported a loss during that time, but is expected to be profitable for the year ending December 2012, and then grow earnings at an average rate of about 14% for the next five years. Based on next year's estimated earnings, GSE is trading at a price-to-earnings (P/E) ratio of about 7.7, well below the market average of 14.1.
GSE has only been trading since February, and has been trending lower almost that entire time. However, it is extremely oversold and it looks like it is time to buy. The chart shows that the stock recently fell to a new 13-week low while stochastics is signaling a buy.
Bottom fishing should combine high potential rewards and low risk, and this trade does that. This is a simple trade with well-defined risk, using a close below the 13-week low at $8.05 for a stop-loss. Resistance at $11 offers a target for the trade and a potential reward of about 27%, which is almost four times greater than the risk of about 7%. At the price target, GSE would still be attractive to value investors with a P/E ratio of about 10.
Action to Take --> Buy GSE at the market price. Set stop-loss at $8.05. Set initial price target at $11 for a potential 27% gain in three months
This article originally appeared on TradingAuthority.com:
Indicator With 70% Accuracy Says This Stock Could be a Bottom Fisher's Dream