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Don't let the spike in share prices fool you

Volatility is the size and speed of price movements we see on markets.

Wildly volatile stocks will move by large percentages, and such moves are often considered a friend of both the trader and investor.

Traders like wild swings as they can make a profit faster, especially when they are using derivatives for gearing.

But volatility actually often hurts traders as a large move can be against their position, causing them to stop out at repeated large losses.

The brief spike

Investors like such jumps as downswings give them an opportunity to buy the stocks they like for less.

But the problem for investors is when the volatility swings high and they tend to have knee-jerk responses. A sudden upward spike can get investors all excited.

Thinking that the downtrend is over, they jump, without careful consideration, to buy the stock.

However, this is only a brief upward spike in the price while the share is actually moving lower, so the investor ends up owning a share that is on a downtrend.

The short squeeze

This is partly due to a short squeeze: Under the assumption that a stock is falling, it’s likely there will be a number of people that short the stock – i.e. sell a stock they don’t own, or have borrowed, at a higher price, with the belief the price will decline.

The idea is that they’ll buy it back at the lower price, making a profit.

But a sudden move higher means they have to buy the stock to close the position.

Now not only are long traders buying along with investors, but the short traders are also buying in order to exit and avoid losses.

This is called a short squeeze and can cause a share price to rocket, making it look like the ‘real deal’.

An example would be Lonmin’s 27% upward move on 7 October. After a day or three, the short traders are mostly flushed out and suddenly buyers are missing, and the stock moves lower again.

This brings short traders back into the markets, where they are now selling the stock, causing it to move lower again.

Is it really the bottom?

The investor sees a sudden large spike in the price of a stock they have been watching.

The stock has been moving lower for a long time and suddenly it starts moving higher, adding maybe 20% or more in double-quick time.

The investor worries about missing out on buying the bottom and jumps in.

But was that really the bottom? In truth we don’t know. But the investor has been pulled into what may or may not be the bottom.

If it isn’t, they could be in for some serious pain as the stock moves lower, potentially costing all the recent gains and more.

The issue is that the investor is scared of missing out and ignores the risk.

The investor wants to catch the stock as close to the bottom as possible so that they can make as much money as possible.

But by getting it wrong, they end up losing a lot more than they ever anticipated.

Instead, the investor should wait for the reversal to confirm itself and buy when they have greater certainty.

Sure, they’ll miss out on a lot of the initial profits, but they’ll have a much lower risk and there will still be plenty of profits to be made. I call this the ‘bit in the middle’.

Forget tops and bottoms, aim to catch the bit in the middle; it offers plenty of profit with much lower risk.

If Anglo has bottomed and is moving higher, the eventual profit is likely to be measured in hundreds of percent.

Missing the first 50% or so does dent the return a bit, but the investor will still get a great return.

This article originally appeared in the 22 October 2015 edition of finweek. Buy and download the magazine here

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