Stock Trading - Timing the Market

Stock trading – timing

You don’t need to be the first person onto an idea to make money, you just have to avoid being the last. Having the view that a stock price may rise or fall is one thing, but knowing when to buy it is another. When investing in the stock market, buying too early or too late can be disastrous, and for this reason many stock traders fail to make the trade at all or panic and ignore their teachings. The two most common errors are to either watch stocks fall and buy them because they’re cheap, or to watch stocks rise and sell them because they’re overpriced. Both trading models are inherently risky because you are taking a contrarian view – going against the trend – and as such the average investor often loses money.

One saying is that ‘it is time in the market that counts, not timing the market’. There is certainly some truth to this, since on average stock market returns are positive, so by leaving your money invested in something you should make money over the long run. But try telling that to the investors who bought the American S&P index in 1999. They’ve made 0 profit over the last 12 years, and when you account for the buying power you lose due to inflation, that’s a big loss.

Timing stock markets more safely

My personal trading style is often based on momentum - following the trend – and whilst I’m not saying that’s the correct model to use, it offers an appealing reward to risk ratio. If you look at any chart you will notice that in between the start and finish there are often many rises and falls. As a stock trader with the ability to go long (buy) or short (sell and buy back later), you could have potentially sold at the top of every spike, bought it back at next the bottom, sold again at the top of the next spike and so on, until you reach the present day. Undoubtedly this would generate a higher profit that if you were either bought the stock at the start and sold at the end, or vice versa. But how do you know when the stock has reached the highest point of its spike, or the lowest part of its fall? The example chart below is the S&P500 over 2011, with green rings indicating buying at the low points and the red circles representing selling at the high points.

The truth is you can never know, and whilst you may hold the view that the stock can’t go up or down anymore, it’s the view of the other 99.9% of the market that will make the difference. The riskiest time to be buying a stock is when it’s falling, and the riskiest time to sell a stock is when it’s rising. Put simply, if people were willing to sell the stock last week, and you decide to buy it, why would they stop selling it now? Of all the days they pick to change their mind and start buying it again, why today? Timing the market is about looking for an entry point which considers the risk as well as the return, and whilst there are often profits to be made when a stock has risen or fallen a lot there are less risky times to enter the market and make money from the trend reversing.

If you look at the same chart again, having worked out how much you would have made by buying at the bottom of the falls and selling at the time (for each large up and down movement it makes), imagine catching half of each of these movements (multiply your profit by 50%). This is equivalent to buying the stock once it has risen slightly of its low, and selling it once it has made its high and is starting to fall again. On the whole, this number will still result in a much higher profit than if you bought at the start and sold at the end, or vice versa. The key advantage is that your chance of success is far higher, as you are running with the market rather than against it, and it is much easier to formulate a trading model or strategy to decide how far off the low the stock price must be before you buy it, or how far of the high it must be before you sell it. As previously stated, you don’t need to be the first person onto an idea to make money, you just need to avoid being the last.

In the pipeline: How to make simple trading models

Bullish on: BHP, RIO (China easing monetary policy will boost growth and the stock price of Australian miners)

Bearish on: US Treasuries (yields too low relative to stock market)

As always, please leave any questions or comments that you may have, and if you want to read some more trading strategies, try www.pimmtrading.blogspot.com