Do you ever feel the sudden urge to purchase a stock when it sharply drops? Many investors are often tempted to do so as they see an opportunity to buy at a lower price. However, the 3-day rule advises investors to wait for a full 3 days before buying shares of the stock. This rule clarifies the importance of patience in making best high return investment decisions.
What is the 3-Day Rule in Stocks?
There are many written and unwritten rules regarding topics that different types of investors or day 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 investing strategy by calculating risk.
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.
Institutional investors rarely sell all their shares at once when they want to exit a position. Instead, they choose to spread their sales over 2 to 3 days. This approach is adopted to prevent a stock from experiencing a drastic decline due to high sell volume. By selling gradually, they aim to maximize their selling price. Although this continuous selling does cause the stock to drop further, it is not as significant 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 typically settle on the following business day.
The 3-Day Rule Benefits You in What Way?
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.
After 3 days, you have the chance to analyze and comprehend the news or event that caused the sharp drop in a stock. Instantly buying into a stock that has declined by 50% may result in regret if you later discover that the reason was the company going bankrupt.
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.
After conducting thorough research and gathering information from open sources, determining that the investment is reliable, include the stock in a watchlist. This will enable you to closely monitor its price fluctuations. Moreover, adding the equity to your stock market watchlist will help ensure that you do not forget its name and you can adjust your finances accordingly.
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 from the settlement date.
When talking about the trading strategy, investors may want to be wary of trading with the 3-day rule in the following scenario considering the company's market value in place.
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 and according to the law, it is not considered favorable as a corporation.
The stock experienced a significant decline of almost 30% from the close of the market on September 9 to the opening on September 11 as liquidation of the stock began. Within three days after the initial drop, the stock further decreased by approximately 35%, reaching a value of $32.83. Investors who adhered to the 3-day rule would have observed the stock's continued decline on the third day, indicating a potential opportunity to purchase and market value has declined.
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.
Frequently Asked Questions
Why does it take 3 days for stocks to settle?
When you trade a stock, the ownership of the share transfers, but the actual shares themselves do not transfer until 3 days later. This is because of the SEC’s 3-day settlement rule, also known as the T+3 Settlement Cycle.
Can you buy a stock and sell it the same day?
Stocks can be bought and sold within 3 days. However, it is crucial to ensure that the purchase price is fully paid before selling the stock. Selling the stock before full payment can result in a free-riding violation, which leads to a 90-day account freeze.
How long should I hold a stock to avoid taxes?
Any profits gained from the sale of a stock are subject to taxation, with rates of 0%, 15%, or 20% depending on the duration of share ownership. If shares were held for a period of one year or less, taxpayers will be subjected to taxation at their applicable ordinary tax rate.
