Are
stock prices real?
One of the
debates that have been carried out in certain financial circles
is the idea of “Market efficiency.” It goes
something like this. Are the current prices of stocks and other
financial instruments representative of realistic value? It is
argued that by the time an individual investor considers the
purchase of a particular stock, for example, all the reports
(good or bad); future expectations or concerns have already been
factored
into the current share price.
If this “Efficient
market” theory
is correct, then it becomes challenging for a stock market speculator
to find under-priced stocks to buy. Viewed on the whole, the
stock market certainly does display price efficiency over time,
but there is an important
dynamic involved that opens windows of opportunity if you know
how to find them.
There are,
in fact, brief periods of clear inefficiency in pricing that
allow individuals chances to cash in. Because of over-reactions
to news or world events, whether good or bad, security prices may
swing wildly. These over-exuberant buying or selling sprees pull
prices into inefficient territory. The market will soon pull these
inefficient prices back to a more normal range and thus return
them to relative efficiency.
One of the
best ways that I know of to make consistent profits in the stock
market
is to capitalize on these brief departures
from normal/efficient territory by opening positions that benefit
from their return to efficiency. I’ll show you what I mean.
Share
prices of CAH dropped about $10 in one single day in July. This
was an enormous percentage loss for CAH. When you see this
kind of price change in one day, the first question that comes
up is “Why?” What could be so terrible as to cause
this kind of carnage?
How Bad is Bad?
Here is the
interesting thing in all this. Quite often the bad news just
isn’t so bad. This is an example of the over-reaction
I mentioned earlier. Market participants–both professional and
novice–very frequently hear some bad or good news and then just
go crazy! When they do, we have a prime opportunity to make some
money. What if we were to buy some shares of CAH after we checked
the news and decided that the bad news wasn’t really so bad
and that CAH is not going broke as the temporarily insane selling
might suggest? On the next chart, we’ll add the price action
that took place on the very next day after this incredible selling
fit.
In
spite of the unusual amount of selling and resulting price loss
of CAH
shares on one
day, the very next day showed a good
amount of buying and price increase. Enough people had woken
up the next morning and said to themselves, “Hey, it’s
not that bad. CAH is actually a bargain at this price. I think
I’ll buy me some!” And buy they did.
In fact, the
buying was not restricted to the day after the plunge but continued
on through the date of this writing as shown in the
third chart below.
The Insanity of Others can be Good for us! There are a
number of trading techniques that take advantage of temporary
market pricing inefficiency. Until you become familiar
with using them, it does take a bit of courage to go against the
stampede of other investors and traders but if you do, the pay
offs make it well worth the effort.
I suggest that
you try this simple technique as explained here with paper trading
first.
Here is how to do it step by step. I
call this “Slamming”
How to Become a Slammer
- Find
stocks that have been hammered by 15% or more in one day. You
can find these listed in the Investors Business Daily or
at Yahoo Finance.
- Choose
only strong Blue Chip companies to do this with, such as those
listed on the NYSE.
- On the
day following the slam, paper trade a small number of shares
of the slammed stock.
- If over
the next few days the price goes down further, buy more. This
lowers your overall cost. Unless the
company goes down the
tubes your potential to profit in the near-term is
very high.
- If the
stock immediately rebounds after the slam day, sell your shares
for 10% or more gain.
Conclusion
Though the
stock market retains general price efficiency over time, there
exist brief periods of distinct price inefficiency which
can provide highly profitable opportunities for anyone willing
to capitalize on them. By following a clear plan of action you
can make excellent short-term gains with high probability trades.
Open these positions with a small number of shares, especially
as you are beginning. Be sure to first paper trade to gain experience
and confidence before committing your dollars to the markets. If
after opening your initial position, the price moves down further,
consider buying a few more shares. If, on the other hand, the share
price moves up after opening your initial position, take profits
quickly. A series of 5%, 10%, 15% or 20% gains in a matter of
days, will add up to enormous annualized returns–far more than
mutual funds or other buy-and-hold strategies will likely accomplish.
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