Have you ever felt the sudden urge to buy a stock as soon as you see it fall sharply? Many investors are often tempted to do so as their minds immediately begin to see an opportunity to buy the stock at a discount. Though it is true that sudden drops cause stock sales, the 3-day rule explains why investors should wait a full 3 days before buying shares of the underlying stock.
What is the 3-Day Rule in Stocks?
There are many written and unwritten rules regarding topics that different types of investors or traders often abide by. While most apply to select groups, the 3-day rule is one that anyone who participates in the stock market can incorporate into their strategy.
In short, the 3-day rule dictates that following a substantial drop in a stock’s share price — typically high single digits or more in terms of percent change — investors should wait 3 days to buy.
Why Wait 3 Days to Buy a Falling Stock?
Sudden drops in stock prices can trigger margin calls in accounts that either bought the stock using leverage or entered into options contracts using leverage. These margin calls can trigger additional sales the next day, driving the price down further.
Additionally, institutional investors that want to exit a position almost never dump their shares all at once, instead electing to spread their sales over the span of 2 to 3 days. The reason for this is because high sell volume will cause a stock to nose-dive, so instead of selling as fast as possible, they sell over the course of a few days to maximize their selling price. This continued selling forces the stock to drop more but not to the same extent as the initial drop.
Certain brokers allow you to see what percentage of a company’s shares are held by these institutional investors, a tool that can be helpful in determining how long or impactful an institutional sell-off may be.
Finally, volatility and options activity often come hand-in-hand. On large drops, many options traders look into contract pricing and execute orders. Because these trades are derivative contracts (see Beginner’s Guide to Derivatives Trading), orderflow does not directly impact the stock on that first day. Instead, option orders settle the next day.
How Does the 3-Day Rule Benefit You?
By waiting 3 days to buy into a position, you can grow your profits and lessen your losses. Considering that most stocks trend lower in the days following an initial drop, you can lock in a better purchase price if you are patient.
Waiting 3 days also gives you the opportunity to analyze and understand the underlying news or event that caused a stock to dip sharply — you would regret instantly buying into a stock that has dipped 50% if you later found out that the reason was because the company was going under.
What Should you do During the 3-Day Wait
If you are not familiar with the company, take some time to do the research.
First, make sure you understand why the stock dropped to begin with. Was it definitive news that is detrimental to the company’s future, news causing uncertainty around a company’s future, selloff related to another stock, or simply bad PR? Understanding why the stock dropped is crucial as you will not see future gains on shares if the company’s future is dead.
Second, read about the company you are buying. What do they do? How do they make money? How risky is the business? You would not buy a new pair of shoes if you did not know anything about them. Additionally, take a look at the price history. If the drop has brought the stock back to a price range it normally trades at, maybe the price it fell from was because of a period of volatility and the drop was just a correction.
Finally, learn about how the company fits into its industry and where it trades relative to peers. If the company is in a dying industry it may be safer to stay away from the stock. You can use different multiples such as P/E, EV/EBITDA to see how the stock is valued relative to its competitors.
When you’ve done your due diligence and have decided that the investment is sound, add the stock to a watch list so you can continue to follow its price movements. Adding the equity to your stock market watchlist can also help you to not forget the name.
Are There Exceptions to the 3-Day Rule?
In terms of the SEC 3-day settlement rule, there are no exceptions in that a share must be transferred and settled within 3 days of a sale.
When talking about the trading strategy, investors may want to be wary of trading with the 3-day rule in the following scenario.
Material News Impacting a Company’s Future or Core Business
In the event that stock market participants discover a drastic change in business fundamentals or the viability of a business and/or its goods or services, the drop in share price is not a discount for the stock, rather a repricing.
Let’s use Nikola in September 2020 as an example. Up to this point Nikola was one of the hottest names in electric vehicles. The company’s share price was surging all summer, at one point hitting a high of nearly $55 per share on September 8.
On September 10, short-seller Hindenburg Research released a scathing report exposing that everything the company had promised was a lie, from the fully electric trucks to its hydrogen fuel station network.
This caused the stock to plummet nearly 30% from market close on September 9 to market open on September 11. By the 3rd day after the initial drop, the stock had fallen nearly 35% to $32.83. If investors followed the 3-day rule, they would have seen that the stock hit continued to drop through that 3rd day, marking a buying point.
Since then, however, the stock has halved and lately hovers between $13 to $17, only passing the $32 mark in the final week of November 2020. Nikola will likely not return to its highs in the near future as the company is now worth significantly less than it was before the lies were uncovered, meaning that investors who bought in 3 days after the initial drop will likely need to sell for a substantial loss.
Benzinga’s Best Online Stock Brokers
Check out some of our favorite online stock brokers below.
Patience is a Virtue
Everyone is always looking for a good sale. By having a little bit of patience and following our advice above, you will be able to get in on even greater stock sales than anticipated.
At this point, you are probably wondering how you are going to find and identify stocks offering the best discounted prices. Thankfully, Benzinga does the hard work for you and lists the top gainers and losers of the day on its Stock Movers page.
Frequently Asked Questions
Why does it take 3 days for stocks to settle?
After you trade a stock ownership of that share transfers, however, the shares themselves will not transfer until 3 days later. This is due to the SECs 3-day settlement rule or T+3 Settlement Cycle. The reason for this rule is so that people or computer algorithms at clearinghouses and brokerages can verify the trade, ensure both the buyer and seller account numbers are valid, and make sure other details such as who should receive a dividend payment for the shares are hammered out.
The SEC amended the rule in 2017 to 2 days to account for the speed of new technology and increased trading volume, yet it is still commonly referred to as the 3-day settlement rule.
Can you buy a stock and sell it the same day?
With the innovations in fintech bringing us new technology, trades and shares are being executed and transferred faster than ever before. It is possible to buy and sell a stock within 3 days, however it is vital that you make sure you’ve fully paid your purchase price at the time you wish to sell your stock. If you pay for part of your stock with unsettled cash and then sell the stock before you have fully paid, you could be committing a free-riding violation, which carries a 90-day account freeze. Trading stocks daily should not be an issue through most brokers, but your safest bet is to verify with your individual broker firm.