Category: Traders’ Secrets

Traders’ Secrets is something that everyone would like to know, right?
How is it possible that some traders are successful all the time while others fail to make a profit all the time?
That is exactly what Traders’ Secrets will show you.
Traders-Paradise’s team reveal all trading and investing secrets to you, our visitors.

What will you find here?

How to find, buy, trade stocks, currencies, cryptos. You’ll find here what are the best strategies you can use, all with full explanation and examples.
Traders-Paradise gives you, our readers, this unique chance to uncover and fully understand everything and anything about trading and investing. The material presented here is originated from the experience of many executed trades, many mistakes made by traders and investors but written on the way that teaches you how to avoid these mistakes.

Moreover, here you’ll find some rare techniques and strategies that are successful forever, for any market condition. Also, how to trade with a little money and gain consistent returns. By following these posts you’ll e able to trade with greater success. You’ll increase your profits and your wealth, of course.

The main secret of Traders’ Secrets is that there shouldn’t be any secret for traders and investors. Rise up your trade by reading these posts, articles, and analyses!

You’ll enjoy every word written here. Moreover, after all, your trading and investing knowledge will be more extensive and effective.

Traders’ Secrets will arm you with those skills, so you’ll never have a losing trade again.

CAGR – What Is It And Why You Should Know

Just like any other metric, CAGR is helpful but is more valuable as part of a larger analysis. Investors would need to look further.

When new investors ask what is CAGR they have in mind some complicated formulas and Excel. Well, yes it is but it isn’t so complicated and Traders-Paradise will explain all about CAGR.

As first, if you want to build wealth, you have to hold an investment that provides you compounding. That could double your investment.

CAGR reveals how much your investment increased over time. It represents the average returns you have earned after some period. That period must be longer than one year. But here we come to the main point of compounding. If you count that only one stock could provide you a steady rate of return every year, forget it. The rate is changing. You will need to add more investments to your portfolio. And when you do that you would like to know how big is the profit you earned for your investments as a whole. Especially if you reinvest. Let’s say you invested in some company and your plan is to reinvest your gains over 5 years. Compound Annual Growth Rate will show you how much return earned you for each year during the holding period. Remember, you have to reinvest your gains every year.

CAGR is one of the most accurate methods to calculate returns for your investments, for each separately and for the whole portfolio. Basically, it is the best way to calculate returns for everything that can grow or drop in value.

You will find that investment advisors like to use this word CAGR when they want to promote their offers. But we would like you to understand what Compound Annual Growth Rate really means and what represents.

Compound Annual Growth Rate explained

CAGR or compound annual growth rate stands for the growth rate that your initial investment will need to grow to an established level over a given period of time. It is similar to compound interest.

Your investment portfolio will have different rates of return over different times. Let’s say you might have huge gains one year, but the next year wasn’t so good, you made some losses.

CAGR enables you to calculate returns of your whole portfolio over several years. That period can be 3, 5, 10 years and you can easily figure out how your investments have performed over that given period. That can help you to compare your investments to others.

CAGR is a mathematical formula

For example, you invested $10.000 at the beginning of 2018. By the end of that year, your investment grew to $20.000, a 100% return. But the next year you lost 40% and you end up with $12.000.

So, how to calculate the return for these two years? If you try that by using annual return you will not have an accurate result. It will show you the average annual return of 30% on your investments (100% gain and 40% loss). Which is a misleading number, because you have ended up with $12.000 and not $16.900.
The average annual return doesn’t work and you’ll need to calculate the CAGR. So let’s do it.

We have to divide the ending value of the investment by the beginning value of the investment for a given period, in our case, it is 2 years.

Raise this result to the power of 1 divided by the number of years we are doing calculations for, which is actually square root in our case.

And finally, we have to subtract 1 from the last result and multiply the result with 100 to get a percentage.

((ending value /beginning value) ^ (1/2) – 1) x 100

That’s it.

Compound Annual Growth Rate, in this case, is 9.54%

Over the 2-years period, your investment grew from $10,000.00 to $12,000.00, and its overall return is 9.54%.

CAGR actually provides a more precise view of your annual return. Our investment started at $10,000.00 and ended with $12,000.00. In the first year, it grew 100%, in the second we lost 40%. But despite this fluctuation, our investment shows a positive return through its lifetime.

Why use the Compound Annual Growth Rate calculation?

It is a helpful tool to compare different investments over a similar investment range. One of the most important advantages of using CAGR is that it, as a difference from the average annualized rate of return, doesn’t let the influence of percentage changes over the investment’s life.

Our example shows that the investment produced a 100% return in the first year, boosting the value from $10,.000 to $20.000. When you reinvested (our potential scenario) the whole capital you lose 40% and the value of investment fell. But it generated a positive return over the lifetime of two years.

Also, you can use this calculation as help to determine what type of annual returns you maybe need to reach your investing goals. For example, take some imaginary sum into the account and calculate is it good for your goals like retirement or buying a house, for instance.

Disadvantages

The disadvantage of CAGR is that it expects growth to be constant and may produce results different from the real situation when it comes to high volatile investment. Investors use this calculation for periods of 3 to 7 years. Over the longer periods, CAGR could lose some sub-trends, simply it can hide them.

CAGR doesn’t consider investment risk and volatility. It will always show a smooth yield. So, you may think you have a stable growth rate even when the value of your investment is varying a lot.

So, remember this, the volatility and investment risk, are essential to examine when making investment decisions. But CAGR will tell you nothing about them. It does not estimate the non-performance associated circumstances in the change of value.

Bottom line

CAGR or compound annual growth rate is a helpful tool for measuring the growth over various periods. Imagine it as a jump from your beginning investment value to the ending value while you reinvest all the capital all the time.

Using it you’re able to evaluate different investment options. But it will not tell you the whole truth. Analyze investment options by comparing their CAGRs from the same periods’, compare the one investment’s annual return to some other investment’s annual return. To evaluate the relative investment risk you will need a different measure.

CAGR neglects the cash flows or volatility. But in combination with other metrics, it can give you a good view of investments or portfolio.

21st February 2020
How To Read Stock Charts?

Stock charts will provide you the information about the stock’s past trading prices and volumes. This is a remarkable advantage when it comes to technical analysis.

By Guy Avtalyon

How to read stock charts and what they are trying to tell you? How can you use them in making your investment decisions? So let’s see the importance of price action and technical analysis. Because that’s it.

We are 100% sure you’ve already had the opportunity to see the stock charts, for example, Yahoo Finance is one of those places. If you want to get some experience with outlook and parameters, it is the right place. Also, you could see the stock charts when you examine the company’s stock you wanted to buy.

And what can you see?

There are two types of charts: line and candlestick. It looks so simple and a small graph but contains a lot of very important data. For example, you can see the opening and closing price, the lowest and the highest price of the stock, and plenty of other information set in that small image.

What trading charts can tell?

You must know, a chart is a visual illustration of changes in stock price and trading volume. They are not magical or scary. In essence, the charts do one easy job: They want to tell you a story about the stock. Stock charts will give you an objective picture without hypes and rumors. They will neglect even news and tell you the truth and what is really going on with your stock.

For example, when you learn how to read stock charts you’ll be able to notice if institutional investors are heavily selling. That will quickly provide you valuable info on what you have to do. The charts literally tell you that. If you see in the graph the investors are massively buying, what are you going to do? What do the charts want to tell you? They want to tell you: buy too. Or if you see they are selling: sell too. Those investors are heading the exits.

The institutional investors’ buying or selling will shift your stock up or down. And the charts will tell you that on time. So you’ll be ready for action. That is extremely important in the stock markets that are volatile and stock price can change in a second.

How to read stock charts

Reading charts is one of the most important investing skills. Stock charts will tell you if the stock is depreciating or appreciating because they are recording the stock price and volume history. Well, when you grow your skill in chart reading, you’ll be able to find more. You will notice some small, often indirect signs in the stock actions such as whether the particular stock showed some unusual activities.

You choose the type of chart that best suits you, a line chart or a candlestick. But the charts will show you the price of daily changes in its price area.

Let’s breakdown all these bars and lines

You will notice the vertical bars. They record the share price span for the chosen period. The horizontal dash that intersects within the price bar shows the current price. Also, it shows where a stock closed at the end of the day. If the color of the price bar is blue that means the stock closed up but if it is red the stock closed down.

In the volume area, below the horizontal line, you will also see bars but volume bars that represent the number of shares traded in some period, day, week, month, etc. The color of the bars tells us the same as price bars. Also, there you will see the average volume for some stock over the last 50 days.

Charts will tell you all about the average share price over the last 50 days and the last 200 days of trading. But by reading stock charts you will have the info about how the stock price moved compared to the market. It is a so-called relative strength line. When this line is trending up, we can say the particular stock is outperforming the market, the opposite means the stock is lagging the market.

Changing the time period

You can do that and have a look at the daily, weekly, monthly charts.

Daily stock charts will help you to measure the current strength or weakness of a stock. These charts are very useful for identifying the precise buy points and creating a short-term trading strategy.

Weekly stock charts will help you to recognize longer-term trends and patterns in stock prices. The weekly charts use logarithmic price scaling. So, you can easily make comparisons between stocks or the major market indexes.

Indicators in the stock charts

All the charts will come with them. Indicators are tools that provide visual representations of mathematical calculations on price and volume. Well, they will tell you where it is possible for the price to go further. The major types of indicators are a trend, volume, momentum, and volatility. Trend indicators show the direction of the market moving. They are also known as oscillators because they are moving like a wave from low value up to the high and back to low and high again as the market is changing.

Volume indicators will show you how volume is developing over time, how many stocks are being bought and sold over time.

Momentum indicators show strong the trend is. They can also reveal if a reversal will happen. They are useful for picking out price tops and bottoms.

Volatility indicators reveal how much the price is changing in a particular period. So, volatility isn’t a dangerous part of the markets, you have to know that. Without it, traders would never be able to make money! In other words, how is it possible to make a profit if the price never changes? High volatility means the stock price is changing very fast. Low volatility symbolizes small price moves.

Some traders don’t use indicators because they think the indicators can smudge the clear message that the market is telling. Well, that’s obviously an individual approach.

What are Support and Resistance Levels

Stock charts will help you to identify support and resistance levels for stocks. Support levels are price levels where you can see increased buying as support to stock’s price that will direct it back to the upside. Resistance levels, as the opposite, shows prices at which a stock has presented a trend to fall while trying to move higher, and switched to the downside.

Recognizing support and resistance levels is extremely important in stock trading. The point is to buy a stock at a support level and sell it at a resistance level. That’s how you can make money. If some stock has clear support and resistance levels, the breakout beyond them is an indicator of future stock price movement.

For example, you have in front of you the chart and you notice that the stock didn’t succeed to break above, let’s say $100 per share. And suddenly, it makes it. Well, in such a case you have a sign that the stock price will go up. You might see, as an example, that some stock traded in a tight range for a long time but once when it broke the support level, it will continue to fall until a new support level is established.

Bottom line

Knowing how to read stock charts will give you a powerful tool while trading. But you have to know that charts are not perfect tools. Even for the most experienced analysts. If they are, every stock trader and investor would be a billionaire.

Nevertheless, knowing how to read stock charts will surely help you. That may increase your chances of trading stocks. But you will need a lot of practice. The good news is that everyone who spends time and gives an effort to learn how to read stock charts can become a good chart analyst. Moreover, good enough to enhance the success in stock market trading.

Try to learn this. It can be valuable. We’re doing smart trading.

19th February 2020
Exit Strategies For Smart Trading

Most traders fail because they don’t have the exit strategies but they are maybe more important than entries.

Exit strategies for smart trading mean that you as a trader know where to stop losses and take the profit. Of course, you can’t do it randomly by setting stop-loss at 1%, 2%, 5%. Anyone who wants to become a trader must know the statistics: 90% of traders lose money when trading the stock market. Well, 10% make money all the time. Traders-Paradise’s aim is to show you how to trade smart, how to enter the elite club of 10%.
Everyone seeks to be in the 10% who make money, but the number of those who really want to devote is surprisingly small. You will need exit strategies for smart trading.

But there is a problem. Exiting a trade makes traders hesitant. We want to explain exit strategies, their importance, and give you a chance to make a profit, not a loss. In simple words, we’ll explain to you how to do “smart trading”.

Trading is easy but you need the know-how

Stop-loss (S/L) and take-profit (T/P) are the two main points that traders have to plan ahead when trading. Successful traders know there are several possible results in trade. They know that they can exit too early or too late and miss out on the profit. The other solution is to exit a trade at an accurate time which results in making money. We want you to look right there, to the point where you can exit your trade in profit.

Have you ever heard saying “let your profits run”? Well, some will run for a long time but some will fall on the start.

If you want to earn in trading stocks you have to do something that others don’t. You need an exit strategy established for each trade. This means you must have a trading plan.

Knowledge united with experience and effort to produce success

To make this clear, you will not find any consistently profitable trader who will tell you that relies on luck. Every successful trader has great knowledge, experience, and trading goals.

Some statistics tell us that learning to trade stocks requires two to five years of experience. Well, that’s hard work and commitment and there are no shortcuts. Don’t be worried or give up now! Trading stocks isn’t rocket science! The interesting thing with rookies is most of them seek for complicated solutions. Don’t let be seduced by gurus in the industry. The whole thing can be very simple.

The exit strategies for smart trading

One of the exit strategies for smart trading is to use targets to book partial profits. How does it work? Before you enter the position you have to define targets and when they come, take some part of your position off for profit. The portion of how much you’ll take off depends on your risk tolerance and trading plan. An experienced trader will take off 1/3 of their position or even half when the first target is scored.

Advantages

This has several advantages. The stock market is volatile and stock prices are shifting direction quickly, so it is smart to book a part of the profit because you will not like to look at the market going against you. It is a bad experience and painful. So, try to avoid that. Well, when you take off some part of the profit, you will still have the other portion in the game. Smart enough? Anyway, this trading plan is simple. But there are plenty of other exit strategies for smart trading.

One of them is profit targets which means to identify the profit targets for the current cycle of stock. You would like to know where the price is possible to go. The point is to determine if you have to get out or stay in. But placing profit targets shouldn’t be randomly placed. So the most important feature you need is to check if your exit strategy is good. How can you do that – find HERE. This a game-changer. Check it out! Note, you shouldn’t place your profit targets too far away or too close.

Stop-Loss strategy

Did you make your first stock trade? What are you doing now? Are you relaxing and waiting to become a billionaire? Don’t do that! Even if you see your stocks running higher there will be one or few starting to fall. What are you going to do now? You have to know that just one loser can ruin your whole capital.

The point is that the stock market is risky and all money that you invest in stock may end up in 100% loss. Of course, you shouldn’t stop investing and trading. So, just take some steps to ensure that you reduce your losses. There is a way to do it. If you place a stop-loss, you practically ensure that your losses do not exceed a specified amount. A stop-loss order means to sell a stock when it enters an established price or percentage. For example, you bought a stock for $100 and you don’t want to lose more than 7%. All you have to do is to place a stop-loss order at $93. If your stock drops below $93 your stock will be automatically sold. The other possibility is your stock is going up. So, let’s say, it trades at $160. That’s a very nice profit of $60 or 60%. What can you do? Just lock in profit at $130, for example, and set a stop order at the same amount.

The benefits

A stop-loss strategy provides you to stay in the game. If you put a 4% stop on your trades, you will never lose more than 4%, for example. It is simple, yet many traders do not use it. Moreover, they don’t have an exit strategy. We have to say, that isn’t trading, that is gambling.

What stop loss percentage should you use? Some experts’ recommendation is 8%. At the moment you buy a stock, immediately put a stop-loss at the level you are willing to lose. Nothing less, nothing more. You can adjust your stop-loss order depending on the stock price direction.

Why exit strategies for smart trading?

Exit strategies boost assurance and profitability. Calculate reward and risk levels before entering a trade, find a strategy to exit the position at the most profitable price, no matter if you are taking a loss or a profit.

The traders caught the losses due to a lack of exit strategy from the trade before they entered the trade.

The majority just take the position in the stock market. Do they have any idea of where to exit the position? What to do if the stock moves in both beneficial or bad directions? A lot of traders ask for help after taking a position. Hence, you should never fall into that trap. You MUST have exit strategies for smart trading. Otherwise, you will lose your capital, home, family. Exit strategies bring discipline. It is important for every trader to take out the profit at the right time. Let us ask you something. Why are you trading stocks? To make money, of course. That’s why you are in the stock markets. Taking profits is the main goal, right? That is possible only and ONLY if you have an exit strategy.

18th February 2020
80/20 Investing Rule – Pareto principle

80/20 investing rule or Pareto principle is great for individual investors who don’t like conventional rules. It isn’t difficult but could increase the chances of your profit.

Let’s see first what is behind the 80/20 investing rule or Pareto principle.

It’s a saying, which claims that 80% of both outcomes or outputs is a consequence of 20% of all inputs for some event. The 80/20 investing rule is frequently used in many fields not in investing only.

But our subject is investing, where the 80/20 rule means that 20% of the holdings in a portfolio are in control for 80% of the portfolio’s growth. Well, this 20% can be in charge of 80% of the portfolio’s losses.

For example, you can build a portfolio of 20% growth stocks and 80% bonds which are less volatile investments. The 80% will provide you a nice and stable return since the bonds are low-risk, while the 20% in stocks that are considered as the higher-risk investment could give greater growth and higher profit.

Also, you can add to your portfolio 20% stocks in the extended market that cover 80% of the market’s returns. But this can be too risky because the stocks are unpredictable and volatile.

Okay, you wouldn’t believe that the market rises 80% of the time, right? But it is true. But does the market drop 20% of the time? The best way to check this is to check it by yourselves and you will be surprised as well as we were. Advanced traders and investors use this 80/20 investing rule as a great advantage.

How to use the 80/20 investing rule?

Examine your investment portfolio and think which of your investments result in 80% of the returns. What can you see? The stocks are what generates most of the returns.

If it is needed, don’t hesitate to cut off a stock if it looks like it falls into your 80% of your overall investment portfolio in terms of returns. Anyway, we want to give some ideas on how to use the 80/20 investing rule and become a better trader.

First of all, you have to finish some tasks such as evaluating how strong your earning power is and to know the inventory of your assets in the portfolio. What are your best assets in terms of investing? You must know that your portfolio is your financial house and you have to keep it in order. You can do that only if you measure and estimate from time to time but actually frequently. Be reasonable, not too frequently. You don’t need the stress. All you want is to avoid unnecessary risks. Okay, you did this task and periodically just go over these figures to check if they follow your investment plan. It is vital for investing to check the current and potential earning power from time to time and keep an eye on your outgoings.

Let’s follow the 80/20 investing rule.

Investing success depends on a few resolutions. For example, the simplicity of your investment strategy and portfolios.

The main aim of investing: Never lose money. That is the rule No1. This means never bet on price changes and rising markets. You need to build an investment portfolio able to follow this rule. Well, we have to be honest, there is no trader or investor that came into the safe zone and comfortable position with speculating and risking in the stock market. Too many risks will more likely lead you to large losses, not to the profits.

Benjamin Graham said:

“Investment is most intelligent when it is most businesslike.”

What is the right meaning of this saying? Managing the investments is like you are running your own business, your company. So, you have to respect some principles that could lead you to success.

The 80/20 investing strategy

The 80/20 investing strategy is all about increasing the chances of your investment success. Actually, it is all about how to unite your portfolio strength and its resources. But, the 80/20 rule has nothing to do with asset allocation. It is wider than that. The goal is to achieve the highest returns possible.

80/20 rule investing means intelligent investing.

At its essence, the 80/20 rule requires you to recognize the best assets and by using to achieve maximum returns. To do that you don’t need complex math, it’s just a rule.

When the markets are overvalued, why do you have to buy? The risk of loss exceeds the potential return, right?

The 80/20 investing strategy will reduce levels of volatility as we described and reduce the drawdowns. Your assets will really “compound” over the long-term. One of the easiest ways to manage this strategy is to use a moving average crossover. The principal is quite simple. Stay in stocks when the S&P 500 index is above the 12-month moving average, and you change to bonds when the S&P 500 falls below the 12-month average.

Pareto principle

Let’s say your portfolio has many holdings. But it doesn’t matter how many holdings you have, the 80/20 rule or Pareto Principle applies. To win by using the 80/20 rule, you have to keep in mind a few things.

Firstly, 80% of your profit depends on 20% of your activities. You can spend a lot of time choosing some great stock, evaluate it, estimate, try to figure out where to set a stop-loss, basically, you have just a few tasks that should be in your focus. Yes, few but they will generate you a profit.

So what do you have to be considered about? What steps do you have to take? You should know your ideal allocation based on your risk tolerance. Also, you have to rebalance it periodically. Can you see? Just two steps, but important though. With these two simple things, you will have success more often.

And you will see that 80% of your returns come from 20% of your holdings. How to choose the winners? Well, you know, they are companies built to succeed for a long time.

Bottom line

80/20 investing is excellent for individual investors who don’t like to follow conventional rules. It isn’t complicated but could easily increase the odds of your success. Just remember that 80% of your returns arrive from 20% of your holdings. Try to find the winners in your portfolio, play on them and look at how your portfolio will become worth and rise in value.

This 80/20 investing rule or Pareto principle is visible in almost all areas of our lives. The 80/20 rule was developed by Vilfredo Pareto in Italy in 1906. He was an economist and he saw that 20% of the pea pods in his garden produced 80% of the peas. After that, he revealed that 20% of citizens in Italy hold 80% of the land. Well, did the 80/20 investing rule grow in Pareto’s garden? According to the legend, yes.

You can find little scientific analysis that either proves or disproves the 80/20 rule’s validity. But the fact is that many financial advisors and consultants have the 80/20 investing strategy as an offer. Moreover, they have extremely good results.

17th February 2020
P/E Ratio An Quick Method to Value a Stock

Investors use the P/E ratio to unveil the relative value of a company’s stock. Also, the P/E ratio can be used to compare a company’s historical data or to compare markets as a whole over time.

By Guy Avtalyon

The P/E ratio or price to earnings ratio calculates the market value of a stock in relation to its earnings and do it by comparing the market price per share by the earnings per share. To put this simple, the P/E ratio indicates how much the market wants to pay for a particular stock based on its current earnings.

Investors often use the P/E ratio to assess a stock’s fair market value by predicting future earnings per share.

It is one of the most broadly used methods for determining a stock value. It can show if a company’s stock price is overvalued or undervalued. But the P/E ratio can reveal a stock’s value in comparison with other stocks from the same industry. This ratio is also called a “multiple” because it shows how much an investor is willing to pay for one dollar of earnings

That is why the P/E ratio is also called a price multiple or earnings multiple. Investors use this ratio to determine how many times earnings they are willing to pay.

Calculate the P/E ratio

The formula is simple. Just divide the market value price per share by the company’s earnings per share.

P/E ratio = share price/earnings per share

Earnings per share or EPS is the volume of a company’s profit for each outstanding share of a company’s common stock. It is a kind of indicator of financial health. Earnings per share present the part of a company’s net income that would be gained per share if all the profits is paid out to its shareholders. If traders and investors want to discover the financial health of a company they use EPS.
In P/E calculation, the amount of “earnings” or “E” is provided by EPS.

P/E = EPS/Saher Price

Where the symbols show:

P/E = Price-to-earnings ratio
Share Price = Market value per share
EPS = Earnings per share

For example, at the end of the year, ABC company reported basic or diluted earnings per share of $3 and the stock is selling for $30 per share. Let’s find the P/E ratio:

EPS = $4
Share Price = $30

This ABC company P/E ratio was:

P/E = $30/$4 = $7.50

So, the company was trading at ten times earnings. So what? This indicator isn’t helpful without comparison to something. As we said, this figure has to be compared to the historical P/E scale of this company stock, or to peers from the same industry.

For example, this P/E ratio was lower than the S&P 500 (the S&P 500 average is about 15 times earnings) but we can compare this P/E ratio to peers. And we noticed that the company XYZ had the P/E ratio of 11 at the end of the same year. What can we conclude? Well, ABC’s stock is undervalued. It is lower than, for example, the S&P 500 and for the same period, had lower P/E than its peers.

You can calculate this ratio for each quarter also but it is common to calculate it at the end of the year.

Use the P/E ratio to calculate earnings yield

This is particularly useful. The formula is actually inverted P/E ratio and looks like this:

Stock’s Earnings Yield = (EPS / Share Price) x 100

or in our ABC company case:

earnings yield = (4/30) x 100 = 13.33

Can you see, to calculate the stock’s earnings yield you have to divide EPS by share price and multiply by 100 to turn it into percentages.

The earnings yield of a stock is the percentage of each dollar invested in company stocky. It is calculated by dividing earnings per share of the company to its share price.

And as you can see, our ABC company has a low P/E ratio but high earnings yield. That will always be like this, the stock with a lower P/E ratio has a higher earnings yield, and the stock with a higher P/E ratio has a lower earnings yield.

This lets you easily compare the return you are earning from the underlying company’s business to other investments. Also, this will provide you to avoid to get in bubbles, panics, and fears. It gives you an insight into the stock market and directs on the underlying economic facts.

Of course, you don’t need to perform all these math even if it is totally simple. This is especially important for beginners in the market.

The majority of stock market sites will automatically figure the P/E ratio and you can see it immediately. With help of this number, you can understand the difference between a stock that is selling at a high price because it suddenly became an analysts’ darling and a stable company that is out of analysts’ kindness and investors are selling it for a part of what it truly deserves.

The two types of EPS metrics

Forward P/E ratio

The most common types of P/E ratios are the forward (also known as leading) P/E and the trailing P/E.
The forward P/E uses expected earnings guidance instead of trailing figures. It is useful when you want to compare the current earnings to the future.
While it is helpful it also can lead you to some confusion. The main problem is that companies often underestimate earnings. The reason behind this is they want to beat the estimated P/E when they announce the next quarterly earnings. Also, some companies will declare too strong and enthusiastic the estimation but later adapt it in the next earnings report. Of course, there are always analysts to provide estimates but can confuse too.

Trailing P/E ratio

The trailing P/E the most popular P/E metric. It takes into account past performances. To calculate the trailing P/E you have to divide the current share price by the EPS earnings for the last 12 months. Investors mostly like trailing P/E because it is more objective.
But this ratio also has weaknesses since the past performances don’t guarantee future performances. It is always better to invest money based on future earnings chances.

The other problem is the EPS figure is constant. You know the stock price is changing. If some company event pushes the stock price higher or lower, the trailing P/E will not reflective of those changes in full. The trailing P/E will alter as the price of a company’s stock moves because earnings are published each quarter. On the other side, stocks trade every day. That’s why investors favor forward P/E. When the forward P/E ratio is lower than the trailing P/E, you can be sure the analysts are expecting earnings to increase. And vice versa.

What are the limitations of P/E?

The P/E ratio has some limitations. When it is low you may think the stock is good but the stock isn’t good just because it is cheap. You have to know the growth rate, free cash flow yield, dividend yield, and many other metrics also, to make a qualified decision when buying a stock.

Build a diversified portfolio that not only holds assets that were handsome but also reduces risk.

14th February 2020
Adjusted Closing Price – Find a Stock Return By Using It

A basic mistake is considering the closing prices of stocks for analysis instead of Adjusted closing price.

If you’re a beginner in investing, you probably already noticed the expression like “closing price” or “adjusted closing price.” These two phrases refer to different ways of valuing stocks. While with the term “closing price” everything is clear when it comes to the term “adjusted closing price” things are more complex.

When we say closing price it refers to the stock price at the close of the trading day. But to understand the adjusted closing price you will need to take the closing price as a starting but you’ll have to take into account some other factors too to determine the value of the stock. Factors like stock split, dividends, stock offerings can change the closing price. So we can say that the adjusted closing price gives us more exact the value of the stock.

What is Adjusted Closing Price

Adjusted closing price changes a stock’s closing price to correctly reveal that stock’s value after accounting for every action of some company. So, it is recognized as the accurate price of the stock. It is necessary when you want to examine historical returns.

Let’s say this way, the closing price is just the amount of cash paid in the last transaction before the closing bell. But the adjusted closing price will take into account anything that might have an influence on the stock price after the closing bell. When we say anything it is literally anything: demand, supply, company’s actions, dividends distribution, stock splits, etc. So, you will need adjustments to unveil the true value of the stock.

It is particularly helpful when examining historical returns. Let’s do that on an example of dividend adjustment calculation.

The adjusted closing price for dividends

When a stock increases in value, the company may reward stockholders with a dividend. It can be in cash or as an added percentage of shares. Whatever, a dividend will decrease the stock’s value since the company will get rid of the part of its value when paying out the dividends. So, the adjusted closing price is important because it shows the stock’s value after dividends are posted.

Subtract the amount of dividend from the previous day’s price. Divide this result by the same day’s price. Finally, multiply historical prices by this last figure.

For example, the prior trading day was Tuesday and a stock closing price was $50. The day after, on Wednesday, it starts trading at a last price minus dividend, for example, trading ex-dividend based on a $4, so the stock will be trading on Wednesday at $46. If we don’t adjust the last price the data, for example, the charts will show a $4 gap.

What do we have to do?

We have to calculate the adjustment factor,

So, by following already described we have to subtract the $4 dividend from the closing stock price on Tuesday (in our case)

$50 – $4 = $46

Further, we have to divide 46.00 by 50.00 to determine the dividend adjustment in percentages.

46.00 / 50.00 = 0.92

The result is 0.92.

Let’s see how to adjust the historical price.

The next step is to multiply all historical prices preceding the dividend by this factor of 0.80. This will alter the historical prices proportionately and they will stay logically adjusted with current prices.

After stock splits

Stocks split occurs when the price of individual shares is too high. So, the company may decide to split stocks into shares. When the company increases the number of shares, the logical consequence is the value of each share will decrease due to the fact that each share factors a smaller percentage.

In our example, if the company splits each $50 share into two $25 shares, the adjusted closing price from the day prior to the split is $25. The adjustment reveals the stock split, not a 50% decline in the share price.

New Offerings

For example, the company decided to offer extra shares to boost capital. This means the company issues new shares of stock in a rights offering. The right offering means that the shareholders have the chance to buy the new shares at lessened prices.

But what happens when new shares come to the market? The price of the shares, of the same company, that are already on the market will drop. How is that possible? Well, think! The number of shares is increased and each of them now cost less. It’s almost the same with a stock split.

The adjusted closing price values the new offerings and the devaluation of each individual stock.

Find a stock return

A stock’s adjusted closing price provides you all the info you need to watch closely to your stock. You can use some other methods to calculate returns, but adjusted closing prices will spare you time. As we see in the text above, adjusted closing prices are already adjusted. The dividends are posted, the stock’s splits are done, the rights offerings also. So we can make a more realistic return calculation. The adjusted closing prices can be an excellent tool that can help us improve our strategies. Moreover, we can do that in a short time since the adjusted closing price already took into account almost all factors that directly impact the overall return. For example, just compare the adjusted price for a particular stock over some given period and you will find its return.

It’s easy to find historical price data, just download it. Further, mark the column of dates and a matching column for adjusted closing prices and set up in descending order. For example, you want to examine a period from March to October. On the top, you should have data for March and below data for April and so.

Let’s find the return

Firstly, compare the closing price in one month to the closing price from the prior month. To unveil the percentage of return you have to divide the chosen month’s price by the previous month’s price. Subtract the number 1 from that result, then this new result you have to multiply by 100 to turn it from decimal to percentage form.
It should look like this:
In March stock price was $50, in April it was $55, so the return was 10%

((55/50)-1)x100 = 10

Since you have to do this calculation for each month add the column for return if you are working in a spreadsheet.

To calculate the average return for the given period, from March to October, just sum each return for all months you observe and divide the result by the number of months.

Simple as that.

Bottom line

The adjusted closing price is a stock’s closing price on any chosen trading day but altered to cover dividends posted and the company’s actions like split shares and the rights offerings that happened at any time former to the next day’s open.

So, you can see that for serious analysis, the closing price will never reveal the real value of the stock, the stock’s value after considering any company’s actions. So it is always suggested to use the adjusted closing price if you want reliable analysis.

You might also like:

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>>> Indicator Trading And How To Use It

>>> P/E Ratio An Quick Method to Value a Stock

13th February 2020
Stock Market Capitalization Is Important And Here Is Why

Market capitalization represents the valid measure of a company’s value. The calculation is simple and easy but helpful.

By Guy Avtalyon

Stock market capitalization or market cap represents the total value of the company’s outstanding shares on the market. As you can find in our Trading dictionary, this is the market value of a publicly-traded company’s outstanding shares.

It is essential for every investor and whoever enters the stock market should know this. You can often hear or read about stock market capitalization in the news, books, or when financial experts are talking about it. But if you want to enter the stock market or you are already there but without experience, it is so important to understand what the stock market capitalization is.

Why is the stock market cap important? How to use it? Can we calculate it? What does it tell us about a company? Take it easy! We will answer each of these questions and more.
First of all, you can’t find a better measure of a company’s size than the market cap is. If you don’t know the size of the company how can you know what you can expect from its stock?

Luckily, the stock market capitalization is easy to calculate. The whole process is simple and everyone can learn it easily.

Understanding market capitalization

Market cap rates a company’s worth on the stock market where it is publicly traded. But also, it shows the stock market’s opinion of a company’s prospects because it reveals how much investors want to pay for its stock.

Let’s say you want to create an investment strategy. Well, you cannot do that without knowing about the company’s size, risks, returns. Only by having all this data you can create an investment strategy that will help you to achieve your long-term investing goals. Moreover, by knowing the market capitalization of some company you’ll be able to balance and diversify your investment portfolio with a mixture of different market caps.

To repeat, a stock market capitalization notes the total value of all shares of stock of some company. Or simpler, it is how much it can cost you to buy all shares of the stock of a company. Of course, at the current market price.

How to calculate the stock market capitalization?

The formula is very simple and clear. It isn’t like some other market data full of fabrications, twists, frauds. To calculate the stock market cap you’ll need two data. One is the number of shares outstanding and the other is the current stock price.

Once you have all the data, it’s quite simple.

The current shares outstanding x the current stock market price = The stock market capitalization

Simple as that.

But we will give you an almost real example.

Let’s say some company has 5 million shares of stock outstanding and its stock trades at $50 per share. Assume you would like to buy all of them.

5 million x $50 = $250 million

So, you would need $250 to buy every single share of this company. Wall Street would say that the stock market cap of this company is $250 million.

Can you see how simple it is? All you have to do is to gather two figures and multiply them.

Why is this so important concept?

Some would say that this measure has the strengths and weaknesses and such people would be right. And here is why.

If you want to compare one company versus others, the stock prices can give you the wrong picture. Stock market cap will never take into account capital structure specifics and that is what may let the share price of one company to be higher than others. On the other hand, it is good because this provides investors to assume the relative sizes of the companies.

For example, an investor would like to compare the company ABC to the company XYZ.

ABC company’s stock price is, for example, $20 with a market cap of $300 million.
XYZ company’s stock price is $200 and its market cap is $150 million.

Which stock to buy? Cheaper or expensive?

And it’s time to explain this dilemma and how to solve it.

Sizing up stocks

There’s a typical misunderstanding that a company’s stock price is more important than its market capitalization. This mistake happens to new investors. Market capitalization is the main factor when you’re deciding a stock. It can tell you about the value of a company.

How is possible the stock with price at $200 worth less than stock with price at $20?

What you have to avoid is a misconception that the per-share price of a stock will give you any perception of the value in comparison to the other stock. It will never do that. It practically gives no insight to investors. The stock price is something very changeable and various companies have a different amount of outstanding shares. So, don’t pay attention to the per-share stock price since it will not give you even a hint about the value of the company. For that, you’ll need to know the market capitalization figure. We already explained how to calculate the stock market cap.

Market cap measures a company’s size, and size will show you what to expect from its stock if you buy them.

The large companies are more stable, they have proven themselves over time. But here is the tricky part, large companies are limited. Frequently, they have no room to develop further.
As a difference, small companies have plenty of room to grow. At the same time, smaller companies are new, its business is riskier and yet have to prove themselves. Their chances of failure are higher.

Stock market capitalization ranges

Companies are ranged in one of three large groups based on their size. So we have large-cap, midcap, and small-cap.

Large-cap: Market value of $10 billion to $200 billion; usually older, famous companies.
Mid-cap: Market value of $2 billion to $10 billion; these are the companies expected to endure fast growth.
Small-cap: Market value of $300 million to $2 billion; these are young companies usually from emerging industries and new technologies.

But also, we can recognize mega-cap with more than $200 billion, on the top of this range and micro-cap of $50 million to $300 million, on the bottom of this range.

The impacts on market cap

Actually, there are several factors. First of all, important changes in the value of the shares since it can change the number of issued shares. No matter if it is up or down. For example, the exercise of warrants on a company’s stock could boost the number of outstanding shares. That can reduce its current value because the exercise of the warrants is performed lesser than the market price of the shares. Hence, it is reasonable to expect an impact on the company’s market cap.

The market cap will not be changed after a stock split or a dividend. Well, the stock price will decrease because the number of shares outstanding increased after a split. For example, the share price can be halved. Despite the fact that the number of shares outstanding and the stock price is altered, the market cap will stay the same. The same comes with a dividend. When the company issues a dividend, the number of shares will increase but the market cap is the same.

Build a portfolio by using market capitalization

You can divide your portfolio by market-cap size. The smaller companies grow faster, but big, well-known companies provide more stability, also pay dividends. If large caps are decreasing in value, small caps or midcaps may increase and help recompense losses. To build a strong portfolio with a decent mix of small-cap, mid-cap, and large-cap stocks, you have to determine your investment goals, time horizon, and risk tolerance. A diversified portfolio that holds different market caps can reduce the risk and help your long-term financial intentions.

12th February 2020
Earnings Per Share The Meaning and Formula

EPS is important when investors look at historical or future EPS numbers for the same company. Or when they want to compare EPS for a few companies in the same industry.

Earnings per share actually mean a measure of how much profit a company has made. It is regularly for companies to announce their earnings per share quarterly or yearly. Earnings per share or EPS is a powerful metric in a company’s earnings estimates since it shows how much of a company’s profit is allocated to each share.

EPS helps to determine the value assigned to each outstanding share of a company.

Earnings per share is a very important part when examining a business’s fundamentals. It is a ratio for profitability or the company’s market prospect. It is always better when this ratio is higher. That indicates the company is profitable and able to distribute more profits to shareholders or to reinvest in the business. In both cases, the shareholders will win.

Despite the fact that this measure is important, a lot of investors never pay attention to the EPS. That could be wrong because the higher EPS can increase the stock price. And that is strange because EPS can cause stock prices to grow and investors are profiting. So, we think that paying attention to EPS is important for making investment decisions.

On the other hand, so many things can influence this ratio, so investors do look at it but don’t let it change their decisions radically.

How to calculate EPS

For example, a company has a net income of $40 million. Preferred stockholders are getting, let’s say, $4 million in dividends. Also, we found that the company has 20 million shares outstanding for the first half of the quarter and also, 24 million for the second half. That would mean the company has an average of 22 million shares.

So, let’s start to calculate earnings per share. We have to count the difference between a company’s net income and dividends paid for the preferred stockholders. The next is to divide that number by the average number of shares outstanding. And here it is:

$40 million – $4 million = $36 million

$36 million / 22 million shares = $1,64/share

So we can conclude this company’s earnings is $1.63 per share.

Diluted EPS

You can see that this basic formula only takes a company’s outstanding common shares into account. But the diluted earnings-per-share calculation takes all convertible securities into consideration. A company might have convertible preferred stocks, warrants or stock options that could theoretically become common stock. If this happens, the result would be a reduction in earnings per share. A company’s diluted earnings per share will always be lower than its basic EPS.

Basic EPS uses net income, deducts preferred dividends, and then divides by the average number of shares of common stock outstanding during the chosen period.

Diluted EPS doesn’t apply the number of shares outstanding. Instead, it takes into account the number of possible shares outstanding. We already mentioned that the companies can issue stock options (for employees, for example), convertible preferred shares, etc. As they theoretically can be turned into shares of stocks, diluted EPS shows us how EPS would look if all convertible securities are converted into stock. The logical consequence is that there will be more shares and diluted EPS is lower than the basic EPS.

Math is important

Imagine you are a stockholder and suddenly the number of stocks rises. Prior, let’s say, you were holding 5% (this a great portion, indeed) of the company but with an increasing number of stocks, your holdings will be smaller and your part in the company’s earnings shrinks. It is just like you have to cut one apple (ouch!) into 8 instead of 6 pieces. You will get a smaller piece.
If our company mentioned above decides to issue for example 8 million convertible preferred shares, the EPS will be lower using the formula we have. Let’s do some math:

$36 million / (22 million + 8 million) = $1.20/share

Diluted EPS is just $1.20 per share. Compare this figure of $1.20 with $1,64 per share.

Where is the point?

Investors have to calculate both EPS and diluted EPS if they want to know when a company is issuing a lot of stock options or other convertible securities. That may have a great impact on shares when the options are exercised. The stock price will fall and shares will dilute.

Of course, it isn’t a sign of weakness if the company is using options to hire experienced employees or to overcome current salary problems, for example. By issuing convertible stock options the company will have more money to support its growth.

It is important to know that when we are calculating EPS for some well-established company the difference between EPS and diluted EPS can be very small or there will be no difference. But smaller companies, for example, some green and growing, may issue a lot of stock options to hire educated staff and experts. So, take it into consideration when estimating the company’s value and making a decision to invest or not.

Weaknesses of earnings per share

As always, even EPS has some drawbacks. It is really good when the company increases its earnings, there is no dilemma. It is a sign that the company is financially stable and it is worth investing in. But if you want to know about the company’s financial health, EPS isn’t the right metric.

Knowing basic and diluted EPS isn’t always simple. We pointed just two examples but some factors may make it more complicated.

For example, the company may issue additional stock shares or buy back some of its own shares or all of them. Also, it can increase its EPS by reducing the number of shares outstanding. In this case, the net income will not increase. So, we can say that companies can direct investors to believe that they are in better shape than they are in reality. The other drawback is that EPS never takes into account a company’s outstanding debt. Also, data about earnings per share doesn’t provide you info about the capital needed to produce the earnings. To put it simply, you are estimating two companies with the same earnings per share and the same income. One operates with less money to reach those earnings. The other company uses more capital. What do you think? Which one is worth investing in? One company is managing its resources better, it is obvious. But you cannot see that in their earnings per share. That’s the problem.

Bottom line

EPS data is a measure of a company’s profits over some time. You have to compare that data to the previous period’s data and if you notice a positive development, meaning increasing earnings, it is a good indicator. Contrary, you will need additional information and explanation to decide what to do with that stock.
Well, there is always a measure against third-party expectations and it can be very useful since it is transparent.
EPS is good when a company’s profits outperform similar companies in the same sector. But even when EPS is good investors sell stocks. The sell-off is caused by something called the “whisper number.” That is the investors’ consensus, based on beliefs about a stock’s future performance. Anyway, EPS and diluted EPS are important measures that every investor should know to calculate and pay attention to.

11th February 2020
The 60/40 Portfolio is Dead – How to Replace It

Bonds and stocks have only interacted negatively in the past 20 years. Their average correlation throughout the previous 65 years was positive. When this correlation isn’t negative, the 60/40 portfolio is weak in protecting your investment.

We all had believed, for a long time, that the ideal is a 60/40 portfolio, which consists of 60% in equities and 40% in bonds. That excellent combination provided greater exposure to stock returns. At the same time, this mix gave a good possibility of diversification and lower risk of fixed-income investments.

But the world is turning around and markets are changing too.

Experts recently noticed that this 60/40 portfolio isn’t good enough. Portfolio strategists claim that the role of bonds in our portfolios should be examined. They argue we need to allocate a bigger part toward equities.

Strategists report

Bank of America Securities (a.k.a. Merrill Lynch) published research last year named “The End of 60/40”. The strategists Jared Woodard and Derek Harris wrote:

“The relationship between asset classes has changed so much that many investors now buy equities not for future growth but for current income, and buy bonds to participate in price rallies.”

That note by Merrill Lynch caused great turbulence among investors. The point is that your conventional sense of investing 60% of your portfolio in stocks and 40% in bonds is no longer so smart.
Merrill Lynch strategists explained that there are grounds as to why the 60/40 portfolio will not outperform portfolios with more stocks versus bonds in it. Therefore, investors have to allocate a bigger percentage of equities to their portfolios instead of bonds.
This is the opposite scale compared to what investors used for many years. They were investing in equities for price rallies and buying bonds for current income.

How did the 60/40 portfolio die?

For the last 20 years, the golden rule was a portfolio of 60% stock and a 40% bond. Everything was good with that: investors had the bonds in portfolios, a 60/40 portfolio provided them the upside of equities, their investments were protected from downturns. But they gave evidence to investors as to why this ratio should be changed and why they have to add more equities than bonds.

Here are some. Data is for the markets globally. During the last year, $339 billion were in inflows to bond funds but almost $208 billion were in outflows from equity funds. So, we now have a tricky situation. Bond yields had fallen. The consequence is that we have about 1.100 global stocks that pay dividends higher than the average yield of global government bonds.

The global economy slows

We must have in mind that the global economy lags due to the aging society and there were rallies in bonds almost all over the world. It was like a bubble. Hence, the investors who manage a traditional 60/40 portfolio are in a situation that threatens to hinder returns.

“The challenge for investors today is that both of those benefits from bonds, diversification and risk reduction, seem to be weakening, and this is happening at a time when positioning in many fixed-income sectors is incredibly crowded, making bonds more vulnerable to sharp, sudden selloffs when active managers rebalance,” said strategists from Merrill Lynch.

The 60/40 portfolio canceled

The popular rule of thumb: investment portfolios 60% in stocks and 40% in bonds, is smashed. The finance industry did it. Moreover, financial advisors urging investors to hold riskier options since, as they claimed, bonds no longer offer diversification. Hence, bonds will be more volatile over the long run. Further, the 60/40 portfolio has sense in the market conditions when stocks and bonds are negatively correlated. The stock price falls – bonds returns rise both serving as a great hedge, bonds against falling stock prices, and stocks as a hedge against inflation. According to strategists, no more.

This will completely change the portfolio management.

The benefits from bonds, diversification and risk limitation, seem to be missing. The bonds are more vulnerable to unexpected selloffs. The mentioned rule of thumb was accurate for 20 years but not for the past 65. Also, it is noticed that this period of negative correlation between bonds and stocks is coming to an end.

Also, Morgan Stanley warns that returns on a portfolio with 60% stocks and 40% bonds could drop by half in comparison to the last 20 years. Earlier, the analysts and strategists from Guggenheim Investments, The Leuthold Group, Yale University, also prognosticate distinctly lower returns.

How to replace the 60/40 portfolio?

The 60-40 portfolio is dead and it is a reality.

Be prepared, you have to replace it. Some experts suggest keeping 60% in stocks but to hold a position shorter, as a better approach.

But you have to hedge your portfolio. Experts suggest single-inverse ETFs and options for that purpose.

The others think the best way is to replace the 60/40 portfolio with some hedged equity portfolio. This actually means you should have more than 60% in stocks since the stock market is more liquid in comparison to the bond market. For this to implement, it is necessary to have tools. Also, the knowledge on how to use them. From our point of view, it seems that time to forget the 60/40 portfolio is here. All we have to do is to change the mindset and stop thinking about the mix of stocks and bonds. Instead, it looks like it is time to think about changing the net equity exposure.

Maybe it is the right time to hold more cash, which can be a tactical defense. For example, cash can be a part of your 60% holdings when you are not fully invested in stocks. Or you can hold cash in the percentage that previously was in bonds. Also, you can combine it. You MUST build a hedged portfolio to avoid the 60/40 portfolio hurricane that is likely coming.
For example, build a portfolio of, let’s say 75% stocks and 25% your hedge combination. This range can be tighter also.

Honestly, it is so hard nowadays to fit the excellence of the 60/40 portfolio.

Bottom line

The 60/40 portfolio was really good but it had a wild side too. The stock portion was down over 25 years of its 91-year existence. Over those 25 years, the average loss was above 13%. But there were bonds with a gain of above 5%, which reduced some of the losses. This portfolio was stable and reliable and you could use it for a long-time.

The other problem with the disappearance of the 60/40 portfolio is diversification. Is it dead too?

Peter L. Bernstein said, “Diversification is the only rational deployment of our ignorance.” Investors have to figure out different access if stocks and bonds no longer balance one another. This great portfolio will miss everyone. Maybe, one day, we will meet again. But some conditions have to be fulfilled. The interest rates should be 6% again, the stock market valuations shouldn’t go over 15x the previous 10 years’ worth of average earnings. That is hard to achieve now.
R.I.P. the 60/40 portfolio.

10th February 2020
Stock Market Bubble How to Recognize It

What is a stock market bubble? How a stock market bubble is created? What is the definition?

We are talking about a stock market bubble when the prices of stocks rise fast and a lot over the short period and suddenly start to drop also quickly. Usually, they are falling below the fair value.

A stock market bubble influences the market as a whole or a particular sector. A bubble happens when investors overvalue stocks. Investors can overestimate the value of the companies or trade without reasonable estimation of the value.

How does this thing work?

Let’s say investors are massively buying some particular stock. They become overly eager to buy. How does that affect the stock price? The stock price is going up. The traders notice the growing potential and believe that the stock price will rise more and they are also buying that stock with an aim to sell it at a higher price.

This trading cycle has nothing with the usual criteria related to trade. When this cycle lasts long enough it can extremely overvalue the stock or some other asset, generating a stock market bubble that will burst.

Because a stock market bubble is a cycle defined as speedy increase, followed by a decrease.

We would like to explain this in more detail. When more and more traders enter the market, believing that they also can profit and perhaps go on the double, but we have a limited supply of some stock, it isn’t unlimited. So, on one side we have an enormous number of traders willing to buy a stock, and on the other side is a limited number of particular stock they are interested in. The consequence is that the stock price will rocket. That sky-high price isn’t supported by the underlying value of the company or stock.

Finally, some traders realize that the growing trend is unsustainable and start selling off. Other investors start to follow that and catch on and start draining their stocks, in hopes to recover their investments. And here we come to the main point.

The declining market isn’t investors’ darling. The stock prices are dropping, traders who enter the market too late have losses, the stock market bubble bursts or in a better scenario, deflates.

Actually, we can easily say that behind the stock market bubbles lies a sort of herd mentality. Everyone wants a piece of high returns, it’s logical, right? Well, it continues with a downward run.

What causes it?

When eager investors are pushing the value of the stock, much over its proper value, we can say that we have a bubble. For example, the stock proper value is, let’s say $50 but investors boost it at $150. You can be sure the price will go back to its proper value, soon and extremely fast. The bubble will pop.

A good example is the dot-com bubble of 1999/2000. The markets were cut from reality. Investors accumulated dot-com stocks so wildly. How was it possible when they knew that a lot of these companies were worthless? They didn’t care.

That pushed the NASDAQ to over 5.000 points in a short period. That was the bubble and everything got apart very fast and painful.

One of the most famous market bubbles took place in the Netherlands (former Holland) during the early 1600s. It is the Dutch tulip bulb market bubble or ‘tulipmania’.

What happened?

The speculators pushed the value of tulip bulbs sky-high. The rarest tulip bulbs were worth six times more than the average yearly salary. Today, tulipmania is in use as a synonym for the traps due to extreme greed.

That can happen when someone follows some investor and notices how good it is and suddenly that one decides to do the same. But such copycats are not single individuals in the stock market. There are millions doing exactly the same thing. In a short time, everyone is plunging the money and the market reacts respectively by inflating prices. And eventually, the bubble will burst.

A stock market bubble as positive and negative feedback loops

Whatever has begun to shift stock prices up to become self-sustaining is a positive feedback loop. For example, investors hunting higher growth. When prices increase, investors are selling stocks. The others are buying them to profit on the growth. Someone will ask what is wrong with that. Well, new purchasings are driving the prices up higher and more investors are seeking those profits. The cycle is starting. And it is good but only when this positive feedback loop, as economists call this, comes as a reflection of reality. But when the feedback loop is based on fake data or questionable ideas it can be very dangerous. A great example is the Stock Market Crash of 1929. That was a time of blooming speculators in the markets. Speculators are trading stocks with borrowed money. The loan is paid from profit. When speculators have good trades they can make a fortune. In a different scenario, when they try to limit losses on debt, they can lose the shirt.

The stock prices will go down, the other investors will quickly sell with the same hopes to mitigate losses. The prices will go down further and create a “negative feedback loop” and poor market conditions will bloom. This is exactly what happens when the stock market bubble bursts. The stock prices are going down further as investors try to sell their stocks to cut losses.

Bottom line

As you can see, a stock market bubble happens when investors are buying stocks neglecting the value of the underlying asset. It is caused by a kind of optimism, almost irrationally, despite the rule of thumb: avoid impulsive trading.

The crucial nature of a stock market bubble is that trading can go in a direction that is not in your favor. Optimism can fade. Investors seeking higher profits easily can see their own disaster when the growth starts to slip. Why should they stay in positions any longer? They will not, of course. It is opposite, the selling off will start and the stock market bubble bursts. And it can do it for random reasons. Be careful, you can recognize a stock market bubble when everything is done. Only rare investors are able to anticipate it is coming. Well, that’s why they are successful and rich.

7th February 2020