Do you remember a time when you felt a sudden urge to buy something just because it was on sale? But then you waited a few days and avoided that impulse buy that you might have regretted later?
That same logic applies to the stock market, where a “3-day rule” in stock trading can prevent you from making rushed investing decisions. Here’s why it’s a good practice to follow.
What is the 3-Day Rule in Stocks?
The 3-day rule recommends that investors wait three days before buying a stock after a substantial drop in price. It’s a good rule for anybody who invests in the stock market.
Why Wait Three Days to Buy a Falling Stock?
For starters, there are a number of market factors that can keep driving shares down after that initial shock.
A sudden price drop can trigger margin calls in accounts that used leverage through direct purchase or options contracts. Those calls can lead to additional sales on the following day, sending the price down further.
Meanwhile, heavy institutional selling rarely happens at once. Instead, big investors will often spread sales over two to three days to help prevent heavy declines due to the sell-off while maximizing their selling price.
After three days, margin call pressure and institutional selling may have subsided, offering a clearer picture of the stock’s trajectory.
The 3-day rule also gives you a chance to pause and look at the bigger picture. The waiting period helps you distinguish between short-term price movement and fundamental shifts that can have a long-term impact on a stock’s price.
During those three days, you have the breathing room to analyze and digest the event or news that caused the stock to drop. Your initial reaction may be pessimistic, but the subsequent days could reveal whether investors are buying the dip, or that fundamental issues will cause further selling.
What Should You Do During the 3-Day Wait?
Research All You Can
Before buying any stock, research the company. Understand what caused the price drop. Is it news that’s detrimental to the business or that makes the company’s future uncertain? Or is it a one-time PR gaffe or simply a selloff caused by another stock? Thorough research will help you find the right answers.
Look For Similar Drops
Take a look at the stock’s price history. Similar drops may have occurred in the past. If share prices usually return to a normal range, the recent downturn may be a correction caused by market volatility and the stock may be trading at a true discount.
Compare The Company With Its Peers
Learn how the company fits into its industry and where it trades relative to its rivals. If the business is in a dying industry, it may be safer to stay away from the stock. You can use different multiples such as P/E and EV/EBITDA to see how the stock is valued relative to its competitors.
Add The Stock To Your Watchlist
One final step before you put your money to work is to include the stock in your watchlist. This will enable you to monitor price fluctuations, and you’ll be able to take action when the price is most favorable.
Discount vs Repricing
When the stock market discovers 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 temporary discount for the stock, but rather a repricing that could lead to further declines. Following the 3-day rule can help you spot the difference.
Consider electric vehicle maker Nikola. In September 2020, short-seller Hindenburg Research released a report that the company had deceived investors. The stock dropped 10% shortly after the announcement, and within a few days, it had lost a third of its value. As allegations and investigations piled up, Nikola’s founder resigned as executive chairman.
Investors who followed the 3-day rule would have watched the stock’s continued decline and avoided a buy. Since then, Nikola shares have lost almost all their value, and they now trade for pennies apiece.
Frequently Asked Questions
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Don’t confuse the 3-day waiting period with the Securities and Exchange Commission’s T+3 settlement rule. Also known as the T+3 Settlement Cycle. When you trade a stock, the ownership of the share transfers, but the actual shares do not transfer until 3 days later.
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You can buy and sell the same stock within 3 days. But before you sell, you must pay the entire purchase price. Selling the stock before full payment can result in a free-riding violation, which leads to a 90-day account freeze.
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To qualify for long-term capital gain rates, investors need to hold shares for a period of one year or more. Any profit generated from the sale of stock is subject to taxation with rates of 0%, 15%, or 20% depending on the period of ownership.
