3-Day Rule in Stocks

 

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.