Thursday, March 17, 2011

Rally and speculation behavior explained

The basic principle in stock price increase or decrease is the principle of supply and demand in economics.
When there are more people buying then selling, the stock price increases since there is more demand.
When there are more people selling then buying, the stock price decreases since there is more supply.
Based on these simple principle and the understanding of human psychology once can understand the
technical analysis of the stocks in rally or in speculation. With this knowledge one can either go with the crowd or against the crowd to make money.

Another important understanding is that stock price movement is an aggregate activity of thousands of people buying and selling. Information about a particular stock and its visibility are also key factors in stock movement.

Why do we see a pattern in stocks in rally?

When the fundamentals of a company are doing good, if the company is profitable this information is released through quarterly, annual report and meeting and announcements. This is done initially by the company to attract capital and increase productivity. During this growth phase, when profits are soaring, often the stock prices also soar. This is the time when one can observe a rally in stock price. What actually happens when there is an ongoing rally?

Initially the good news when releaed, certain investors looking for good investment opportunities buy the stocks of the good company. Then when the information spreads through news channels, etc, more people become interested in the stock. when they start buying, you can see a leap in the stock price of 15-20 percent or more. Then some people sell and cash out. We see this behavior when the stock comes back near to the 30 day average and hangs around there. Again more people or the same people who took profits earlier jump back to purchase for discount price. Then again we see a spike in price. So the stock price movement is the result of increased demand and profit booking. So the stock moves from near the 30 day moving average to 20-30 percent above it and comes back. this is stage 2.

This way the stock moves up and up. But there comes a point at the top when buyers and sellers are not confident anymore of any price increase. They do not want to buy for any more increase price because they think the fundamentals do not support such increased price. There could be some speculation always possible for a short while but that will not last long. The stock comes back to STage 3. when a plateau is formed at the top.

During stage 4, there are more sellers then buyers. Then the stock starts to slide down. Even the down movement is paused by stock price increases for certain days. This happens because, when the stock is coming down, some people think that the stock is priced at bargain prices and want to buy it.
At this point people who are buying are making a mistake because majority of the people are selling the stock. The minority who are buying will lose. It is like a wave in the sea falling down. Small buyers cannot beat the massive selling . So we see a couple of days of stock rising high but eventually due to the pressure of selling the stock goes down. There is another interesting reason why people actually sell . This has to do with psychology. When the stock start to fall for example if a stock is falling down from a peak of 50, to 46, then people who bought the stock at 48,47,46,45 become tensed. They want to
sell the stock and be on the safe side and protect their capital. When thousands of people show the same behavior you will see the stock falling down rapidly.

That is the reason why the fall is steep then the time it takes the stock to climb to the peak. That is also the reason why if one is able to short a stock one can reap profits faster than buy and hold . A note of caution is that shorting is alway risky and if one does not know how to get out of a problematic situation one can reap huge losses.

Then after the 4 stage the stock comes back to stage 1 when there is an equilibrium of sellers and buyers. the stock price stabilizes at certain price range.

There are many patterns that are formed during a rally. There are 3-4 basic patterns. This pattern is formed depending on the psychology of buyer and sellers and their anticipation of the stock and the way the information is dissipated to the crowd.

If I had the privilage of putting graphs here I  would have done it but I cannot in this blogpost.

What happens in speculation and why is shorting safer than buying during speculation?

An important point is that speculation or immediate profit motive happens with stocks that have good fundamentals and also with bad fundamentals. The difference is that the stocks with bad fundamentals, the stock price falls down the same way it went up and the good one, the stock price stabilizes.
The stock price stabilizes because the majority are holding the good stocks with good fundamentals in anticipation of higher prices and higher revenues or profits in the future.

In contrast the pure speculative bad fundamental companies, the prices comes down soon with in a weeks time.

During speculation, due to some good news about a company there is a sudden peak and high volume
and sudden demand pressure on the stocks. During those times stage 2 becomes a one straight sharp peak to the top. It may take a couple day or more to reach to the top under heavy demand for stocks.
As information about the stock is known through the internet,news and other channels more and more people want to jump in to take the immediate profits. They see it as a great opportunity to make quick profits. But when people are buying, the one who bought initially and sell at the top or the mid way get out with profits but the one who are late comers to the party, often take losses.

During speculation stage 3, is very short. It is only a peak formation or two, which is followed by stage 4.
People who have come as late comers to the party when they see that the stock is not moving any higher, when there are no buyers or when buyers are not willing to spend more on the stock for that particular price, the later comers get stressed and they start selling.

We see this as stage 4. There is heave selling. The stock falls down the same way it went up.
Often during heavy speculation the high price of stock has no connection to the fundamentals of the company. It is pure speculation of buyers and sellers. If one holds such stocks one will see great losses.

Let me explain why buying is dangerous when dealing with speculative stocks. The reason being that when one buys a speculative stock during stage 2, one can never guess when the peak has come and when majority of the buyers start selling and taking profits. One cannot guess the peak just as one cannot guess the bottom ,when people are selling. So the wise thing to do is to wait till the stage 4 comes. When people start selling the stock. This is the time to Short the stock. Now when one short these speculative stock, one is one the side of the majority of the sellers side and not on the side of minority who are buying( who will lose a lot money).
Hence the saying to be one the side of the Market and not to go against the Market.

When the stock reaches stage 1 after 4, when there is equilibrium prices again, one can cover the short position to reap profits.

I hope I made myself clear and explained well. . I have read many books but none have explained properly the exact
behavior of the stocks. Once this stock behavior is understood one can take advantage of it.
Out of all the books I read, Secrets of profiting in Bull and bear markets gives some good understanding about the basics of stock movement. Some of the pieces of the puzzle were being revealed to me lately.

Ask questions if you have any.

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