After you have decided that you want to buy (or sell) a company's stock, the timing of placing a buy (or sell) order is very important.
If you bought a stock at a time when the stock price is in a downward spiral, your trade immediately starts losing money. If you bought a stock at a time when the stock price was already on a rapid upward trajectory, you run the risk of paying a very high price for the stock and the potential risk of an immediate reduction in stock price as the market tries to rebalance and stabilize.
Analyzing the stock price movements and waiting for the opportune time to make your trade is extremely important.
So, the key questions we will answer in this post:
Why do stocks go into a downward spiral?
Why do stock prices go up (sometimes very quickly)?
How do you spot the best time to buy (or sell) a stock?
Gains: Our objective is to make a profit i.e. buy low sell high. Its not necessary that you have to buy the stock at its lowest price ever and sell at its highest price ever to make a return. You can make many small returns on multiple stocks by buying stocks at a price that is not necessarily its lowest price and selling a stock at a price that is not necessarily its highest price. For every buy trade you enter, define for yourself the gain that you are expecting to realize on that particular trade. This will help identify a sell price target. If / when the stock hits this sell price target, you will have two options - Option 1: Realize the gain you expected at the start (or) Option 2: Hold on to the stock for potentially more gains but risk losing all the gains you could realize if you wound down the position now.
Sold / Oversold: If many market participants are selling a stock, the price goes down. If a stock is being oversold, price goes down rapidly. You may think that if the price is going down for a stock that you want to buy, the best time to buy is at a low price but for this you need to have a risk appetite for losses as you may have bought the stock when it is still being dumped in the market, so the bounce back may take longer or may never happen. I'd suggest avoiding stocks that are being Sold / Oversold by market participants.
Bought / Overbought: If many market participants are buying a stock, the price goes up. If a stock is being overbought by investors, price goes up rapidly. You may think that if the price is going up, you should buy the stock. But, there is a possibility that at the time you buy, the price is already at its highest. Therefore, from that point on, the price may go down to stabilize at a lower price relative to the price at which you bought the stock, therefore resulting in losses for you.
Trading Volume: This is publicly available information for every publicly traded stock. If you see a stock price appreciating with substantial increase in daily trading volume, it is likely that many investors are buying the stock at the same time and it is more likely to sustain that appreciation in price. If you see a stock price appreciation on low volume, it could be a 'Dead Cat Bounce' - meaning a short appreciation that will soon follow a downward trend. Logically - when more money from more investors is moving a stock price, it means there is more demand for that stock and the upward trend will be more sustainable.
Options Trading: Option Traders can cause a stir in the stock markets when a put/call option is coming up to an exercise date. They can push a stock towards a Bought / Overbought trend to push the stock price towards the strike price of a Put Option if the strike price is greater than the current stock price. The flip side can happen with a call option i.e. push a stock downwards i.e. sold / oversold trend to push the stock price towards the strike price of a Call Option. Some stocks have weekly options, which provides an opportunity for stock traders to make weekly profits if they spot the trends in the stock price caused by the stir from Option Traders. Weekly Options generally expire on a Friday.
Results Announcements: Research Analysts (Sell Side) provide estimates of where they think a company's quarterly results may land. This will include items like Earnings Per Share, Revenue, Profit, Costs, Cash Flow etc. which will then be extrapolated to inform a price range for a stock that the sell side bankers expect the stock to trade at post the results announcement. If the company's results are significantly better than the analysts' estimates and assuming no other negative story around the company, you will generally see an upward trend. The flip side may also be true. So, before buying a stock, check to see when its next results announcement is due as around their announcements the stock price can go either way depending on the results and this may provide a better opportunity to trade the stock in that window rather than now.
External Factors: When the Fed or any reserve bank makes changes to monetary policy (interest rates or bond buy backs or quantitative easing etc.), the stock market will react and present an opportunity to trade. For example, if interest rates are slashed by the Fed, the US Stock Market generally sees an upward trend because lower interest rates inflate asset prices and investors pour more capital into the stock market and buy stocks, which in turn pushes the prices up. We have seen this happen time and again, presenting a great opportunity for short-term investors/traders to make a quick size-able return on their investment. Having said this, it is important to note that this trend of "lower interest rates inflating asset prices and stock prices as investors pour money into the market" only happens when the investors have confidence in the stock market. During the Financial Crisis 2008-09, although the Fed slashed the interest rates, investors chose to hold cash rather than invest in stock markets which pushed the economy into stagnation for 2-3 years before the US Stock Markets eventually rebounded, resulting in a prolonged U shaped recovery.
Standard Deviation (SD): For the approach we are going to discuss below, understanding Standard Deviation is important. SD provides a measure of volatility, i.e. how far is the current price deviating from the stock’s mean price over a chosen period of time. I generally use 20 day periods to measure standard deviation from a Simple Moving Average (SMA). You can choose a longer period if you wish to but 20 day trading period covers a month of stock's performance and I think this is a reasonable window to analyse the trend of a stock.
So, before we buy (or sell) a stock, we want to do the following:
Identify if the stock is Bought / Overbought or Sold / Oversold
Define a Sell Price Target
Read the news about the stock's results announcements and other news
Read and understand the external factors (like Fed intervention or any other macroeconomic update)
Here is an approach I use for the first two bullets above i.e. when to buy and how to define a sell price target:
Bollinger Bands
Bollinger Bands present an Upper Bound and a Lower Bound. I use two sets of Bollinger Bands to identify a trading action.
First set of Bollinger Bands capture:
Upper Bound (A1) = Current Stock Price + 2 * Standard Deviations
Lower Bound (A2) = Current Stock Price – 2 * Standard Deviations
Second set of Bollinger Bands capture:
Upper Bound (B1) = Current Stock Price + 1 * Standard Deviations
Lower Bound (B2) = Current Stock Price – 1 * Standard Deviations
The first set of Bollinger Bands (A1 and A2) generally capture 95% of the stock’s price movements i.e. stock prices generally always fall between A1 and A2. The Bollinger Bands self-adjust, meaning that they widen at various volatile markets and contract when the market is quiet.
Using the bands, I evaluate the following trade signals:
‘Buy Signal’: When the stock price is between A1 and B1 i.e. Upper Bound of the first set of Bollinger Band and the Upper Bound of the second set of Bollinger Band. This indicates that the stock is being bought by a number of investors, so the price is on an upward trajectory, so a good time to invest. Try to buy the stock at a price closer to B1 and set the Sell Price Target to A1.
'Sell Signal to realize profit': Assuming you bought the stock in the 'Buy Signal' window, wait for the price to hit the upper bound of the first set of Bollinger Bands (i.e A1). Get ready to sell the stock from the point the price is at A1. You have two options at this stage: Option 1: Realize the profit at this stage if you don't want to be too greedy. Option 2: if you have the risk appetite, hold on to the stock to see if there is a downward spiral until about 10% change in price. If there isn't a downward trend, hold on to the stock as it is likely still getting bought by other investors and the price will be driven up to reflect this as the Bollinger Bands move with the increasing stock price. Reset the Sell Price Target to the A1 as the bands move. If you notice a downward trend at any point, cash out and realize your profits.
‘Overbought Signal’: When the stock price breaches A1 i.e. Upper Bound of the first Bollinger Band, it indicates that the stock has been overbought by the market participants, so the price has breached the 2 standard deviation measure. This further indicates that the price is expected to fall before stabilizing between A1 and A2 bands.
‘Watch’ / ‘Do Nothing’: When the stock price is between B1 and B2 i.e. between the second set of Bollinger Bands, do nothing. There isn't enough volatility in the stock to trade at this point.
‘Sell Signal to Stop Losses’: When the stock price is between B2 and A2 i.e. Lower Bound of the first set of Bollinger Band and the Lower Bound of the second set of Bollinger Band. This signal indicates that the stock is being oversold in the market, so pushing the price in a downward trajectory. Execute on this signal only if you want to stop losses. Do not execute on this signal if you have invested in the company to hold for the long term but acknowledge the risk that the stock may never bounce back to make profits or even to your buy price
As an example, see below the Bollinger Bands that I created for Boeing Co, one of the stocks I was tracking to invest in April 2020 but did not get the right window to ‘Buy’ the stock. You can see how the stock was stabilizing at the start of April (with wide Bollinger Bands), by the end of April the volatility had squeezed and the bands got lot closer to each other, therefore providing less-to-no opportunity (or incentive) to trade.
After 03/05/2020 to 06/06/020, here is what happened to the Boeing stock: Stock remained in Watch / Do Nothing window until 18/06, at which point it entered the B1 Bollinger Band at $137 per share and ever since the price took off to $185 in the first week of June, hit $230 by 08/06 and it is currently trading at $184 as I write this post. It may have been hard to get in exactly at $130 and exit exactly at $230 to realize the full potential profit that was available in that window. But, using the bands you could have entered anywhere in that window to make a size-able profit.
So, how do you identify buy/sell signals? Any interesting strategies you follow?
Comments