The Drop in CSX is Overdone: Here's How to Play It

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Yesterday, CSX (CSX) announced that President and CEO E. Hunter Harrison was taking a leave of absence for medical reasons. One hopes that this is only a temporary measure, and that Mr. Harrison can make a full recovery, but the market reaction is what interests me here and it is following a familiar pattern of overreaction.

The stock has dropped close to fourteen percent in after market trading, and is still falling as I write. That looks like an excessive move and presents an opportunity to investors, but jumping straight in may not be the best idea.

It is not that Harrison’s leave of absence is not significant. It is undoubtedly disruptive, as he has only been in charge of CSX since March of this year, but that short tenure is itself a reason to see the selloff as overdone. The importance of CEO’s comes largely from their role as long-term planners for a company. They take a big picture view, devise strategy and implement it. In the nine months he has been at CSX, Harrison has done the first two and begun the execution of a plan.

The appointment of the existing COO, James Foote as the acting CEO indicates that in terms of that plan, nothing much will change. Some degree of uncertainty must exist, but it doesn’t justify the stock being down here.

The question for traders and investors is therefore how best to play the expected bounce-back. The thing to remember is that even if the move already looks overdone, that doesn’t mean that it is over. Once a selloff takes hold it can take on a life of its own as increasingly low levels are achieved, and stop loss orders are triggered. Waiting for either signs of a turnaround or for the stock to hit a potentially significant level is therefore necessary for a play like this.

The most obvious level for CSX is around $48.20, the level marked on the chart above. That would mark a complete retracement of the move up that began a month ago and had proved to be a significant support before that. Even if we get there, though, some caution is warranted and averaging onto a position would be preferable to firing off both barrels immediately.

If I am right, however, and this is already overdone, it is unlikely that CSX will lose another two bucks or so to get to that level and recognizing when a bottom is formed will be key.

As most traders will know all too well, bottom fishing is not an exact science and retracements can be short-lived and therefore expensive. False bottoms are common on a big move, so you need to have a strategy that allows for that. The best comes when a support level is clearly marked, and that is the case when buyers emerge more than once around a price. In other words, look first for a double bottom, and a lopsided “W” pattern as a buy signal.

If that doesn’t come, then the use a break above a Fibonacci retracement level as a trigger. Fibonacci retracements are somewhat mystical, as I explained in this piece, but traders’ familiarity lends them significance. I would look for a bounce back above the first significant level, at 23.6% of the initial move, and enter the trade there with a stop just below the low of the initial drop.

All of that is fine, but if the sellers are right and Harrison’s leave of absence is truly significant even the best strategy for buying the dip will fail. Logic, however, dictates that that will not be true. What Harrison has effectively done in his short time at CSX is to enact a plan to take advantage of improving market conditions, but it is that expected improvement that drove the stock to the recent highs.

Even with the CEO gone, the U.S. economy is still growing faster than in the recent past, and U.S. crude oil production continues to increase. That is why buying CSX in expectation of a recovery makes sense, but doing so with a clear strategy does too.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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