Price Discovery Explained For Beginners

Financial Advise
What is Price Discovery

Price discovery is the process where buyers and sellers determine where a transaction can take place based on supply and demand.

This evaluation process uses the economic concept of supply and demand to find a price where a buyer and a seller agree to trade.

The supply and demand for an asset are based on several factors including the future abundance of an asset in any specific location. Transaction costs, as well as transportation costs and the storage of an asset, can play a pivotal role in determining the price discovery.

The formula to determine price discovery is ever-changing and will be different for each asset.

Why It’s Important

Did you ever notice that when a new company stock trades for the first time on an exchange like the NYSE, it can take a while for buyers and sellers to agree on a price?

What generally occurs is that buyers move their bids higher and the seller moves their offers lower until a trade is transacted. This process is called price discovery. Its were buyers and sellers agree to a price to allow a transaction to take place.

The process of setting a price on any asset, whether is a security a commodity, or currency pair is referred to as price discovery.

Traders will evaluate several factors including supply and demand, risk, politics, as well as the economic environment during the price discovery process.

How Does It Take Place

The study of price discovery is a relatively new theory, but the concept has been around for thousands of years.

Every barter for goods or services is part of the price discovery process.

Every street market where a vendor is willing to negotiate participates in price discovery. As you can imagine this will change from transaction to transaction.

The Development of Price Discovery

The bizarre in China and India provided some of the first marketplaces around the globe. The issue for buyers and sellers was that the same product could trade simultaneously in separate locations and experience different prices.

The supply and demand in a specific location could be very different and it could take weeks or months for buyers and sellers to realize that prices were higher or lower at a different location.

For prices to be consistent they rely on traders to close an arbitrage.

The term arbitrage means the simultaneous buying and selling of assets in different markets to take advantage of differing prices.

A location arbitrage means that the price difference allows you to transport the price from one location to another and still make a profit.

Vehicles and the telephone helped close location arbitrages around the globe.

The modern-day marketplace has morphed from an in-person ring of traders to an electronic auction where traders place bids and offer to help in the price discovery process.

The advent of an electronic auction has increased market transparency, but still provides scenarios where trades can simultaneously take place at different prices.

Sophisticated electronic trading programs are constantly scanning all possible electronic trading platforms to take advantage of any price anomalies.

Price Discovery in the Marketplace

Price discovery is the most important function of a marketplace.

Every market participant has a reason to purchase and sell at a specific level.

As markets become transparent, the liquidity that is provided creates a smooth movement in price action. Consistent price movements due to observable price discovery increase confidence in a market.

When price discovery is opaque, investors tend to shy away from trading.  Opaque markets tend to have wide differences between where traders are willing to purchase and sell an asset.

Generally, fewer traders are involved in opaque markets.

While the difference between the bid and offer will narrow to generate a trade in an opaque market, investors understand that exiting a position could take time.

For example, you should be confident that you can exit a position in Apple shares immediately after you purchase them. This would not be the case if you decided to purchase a cabin in the middle of an uninhabited rural area.

One of the downsides of a highly transparent asset is that large quantities can be moved quickly which can generate whipsaw price movements.

When it Concerns Day Traders

Price discovery mainly concerns day traders on days IPOs open up for trading and there is no previous price action to trade off of.

In the first few hours of trading, shares can be very whippy and hard to trade. This is because it’s the first time the shares have traded on the open market which means there are no real levels of support and resistances.

This means shares can be very volatile. Trading with that type of price action can be hard to manage risk which could end up costing you a lot of money.

One way to approach IPO trading, especially for beginners, is to let the morning trading cool off. Let the stock establish levels of support and resistance.

This will give you something to trade off of and provide you with a way to manage risk.

In the example above, Palantir Tech (PLTR) opened up for trading on September 30. Prices were going back and forth between $10.20 and $11.40 before settling down and establishing and trading range.

Then you can see that at $10.60 prices started to hold on multiple occasions before breaking down and trading lower for the rest of the day.

This is what you want to wait for, especially on IPOs.  Allow prices to establish some sort of price discovery to trade from and then take advantage of the moves when they breakup/down.

Price Discovery and Valuation

When markets are active with thousands of traders placing bids and offers, they tend to be transparent. The price discovery process can be relatively easy. Price discovery is not the same as valuation.

The process of trading uses a model-driven concept to determine that the current price is either overvalued or undervalued relative to future prices. This differs from price discovery which is a market-driven concept that determines the current price of an asset.

Terms such as fair value, focus on the future value of an asset relative to price discovery which is geared to determining the current value of an asset. For traders, price discovery provides a key metric for determining future price values.

For example, if you don’t know the price today, you cannot bet on the future price value.

What Influences Price Discovery

Several factors influence price discovery.

Some of these impetuses include:

  • Availability of an asset
  • The demand for an asset
  • The available information
  • Whether the asset is fungible (meaning it’s the same assets in all locations)
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Dotcom Bubble

Finance News
What is the Dotcom Bubble?

The dotcom bubble was the exponential rise of tech stock prices between 1995 and 1999. While tech stocks were on fire throughout the late 90s, the real explosive growth came in 1998 and 1999.

The period was a time of market mania in which plumbers and mechanics were becoming millionaire day traders, tech IPOs would multiply on their first days of trading, and vanity metrics such as “eyeballs” or “mind-share” were becoming serious valuation metrics for analysts of technology companies. 

While the dotcom bubble spawned many spectacular failures like Pets.com and Webvan, some of the largest companies in the world went public during this time.

Companies that shape the world we live in today, like Amazon, eBay, and Priceline. Others, like Google and Netflix, were privately founded during the bubble. 

Once the bubble popped, the NASDAQ 100, the index which featured the most prominent tech stocks of the era, had dropped more than 80% peak-to-trough.

Dotcom Bubble Chart
Dotcom bubble

 When you hear trader interviews on a podcast like Chat With Traders, they speak of the dotcom boom as a time of unconstrained mania that will never return.

A time when just about anyone can make a fortune trading, even without a sound methodology. “Taking candy from a baby” is a common analogy. 

Bubbles tend to occur during times when credit is freely available, and other macroeconomic factors like unemployment and inflation are at healthy levels. When lending is permissive, companies that wouldn’t survive under less favorable conditions get funded and contribute to the bubble.

Of course, macroeconomic factors are just one piece of the puzzle. 

As you’ll see in this article, I think people tend to oversimplify how many factors lined up at just the right time to create this bubble. The bubble can be attributed to the culmination of several factors in the flavors of the rise of the internet’s utility for commerce, socioeconomic trends, macroeconomic trends, and trends in demographics. 

The Early Seeds of the Dotcom Bubble

The boom was the perfect storm of a few factors that contributed to the rapid across-the-board growth of US equities, and tech stocks in particular.  

Most commentators and pundits refer to the rise of the internet in the mid-90s as the catalyst for the bubble. Still, the first seeds of the bubble were actually planted during the US presidential election of 1980 when Ronald Reagan campaigned for social security funds to automatically be invested into the stock market.

In the coming years, Americans would become consumed by stocks and the economy defined by markets. 

Until the 80s, the stock market was seen as a dull, old man’s game. Most savings were invested in bonds and securities other than stocks. Any run-up in the stock market would be accompanied by a congruent downfall in prices, presenting itself as an unattractive place to park your money.  

Americans who lived through the Great Depression were forever skeptical of the stock market. Significant bubbles couldn’t happen because not enough people would get involved.

Those who did still had their Depression-era ideals, that anytime the getting is too good, a Depression is probably right around the corner.

Market skepticism was a safeguard against bubbles. It wasn’t until the baby boomers were ready to start investing that a real bubble could inflate. 

By the late 1980s, when Alan Greenspan took over as the Chair of the Federal Reserve, the stage was being set for a massive stock market bubble. Americans were already interested in stocks again due to the rise of the hostile takeover, creating enormous price spikes in declines in just one day. 

The market was getting ready for a bubble; it just needed boomers to get a bit older, and a new catalyst: the internet. 

How Did the Dotcom Boom Happen?

When looking back at the period, there were so many factors converging at the same time that laid the groundwork for a massive asset bubble.

The most obvious is that the internet was becoming advanced and ubiquitous enough that it began to have serious potential for businesses.

Still, several other factors were at play, all acting as contributors to the bubble.

The Demographics

Baby boomers were the largest American generation up until that point. As a consequence, their attitudes and situations at any given time shaped that of the entire nation. In the late 1990s, 76 million boomers were entering their prime earning years–their 40s and were beginning to save and invest for retirement.

 Boomers, who were about to become the largest buyers of stocks, were especially ripe for building an asset bubble because throughout their entire lives up to that point, stocks have basically only gone up.

They hadn’t gone through the Great Depression and developed the market-skepticism of their parents.

The Economy

The 1990s economy under Federal Reserve chairman Alan Greenspan, or ‘Uncle Alan’ as Wall Street fondly called him, was referred to as the Goldilocks Economy. The level of unemployment, inflation, and interest rates was just right.

 Greenspan was a fan of expansionary monetary policy.

He favored lowering interest rates when he could to stimulate the economy, and as a result, the stock market. Uncle Alan also adored the new technological advancements coming out, and largely bought into the dotcom hype.

 Throughout the bubble, each time stock prices would fall, Wall Street would trust that Uncle Alan would be there to ‘save’ the market. In later years, Greenspan would admit that he and the Federal Reserve made many mistakes in the handling of the tech boom.

The Advent of Financial Entertainment

If you’re an American, you’re undoubtedly familiar with 24-hour news networks like Fox News and CNN. Endless pontification, oversimplification, and verbal quarrels for entertainment, not informing the public.

 You might be surprised to hear that CNBC served as a proof of concept for these networks. Roger Ailes, a media executive, known for turning Fox News into what it is today, first tested the “entertainment news” idea on CNBC when he became the president of the network in 1993.

CNBC anchors began reporting market news with the same excitement and suspense as a sportscaster like Chris Berman.

 The network made trading and investing fun and easy. CNBC replaced local news and even sports as the programming of choice at restaurants, cafes, and bars. It wasn’t abnormal to see CNBC playing in an NYC pizza joint.

Democratization of Investing

Before the advent of online discount stock brokers, Americans were used to full-service brokers, from whom they were charged sky-high commissions for stock tips and investing advice. Most deferred to the wisdom of their broker and seldom concerned themselves with the gyrations of the market.

 Online brokerages like E*TRADE, Datek Online, and Ameritrade enabled retail investors to fire their brokers and make trades for a fraction of the former cost, at the click of a button.

As much as 40% of individual investors with financial assets between $25,000 and $99,000 made their first stock trade after January 1996.

These greenhorn investors were chasing the hottest tech IPO, hoping to double their money overnight.

Valuation Confusion

Internet companies were a whole new breed. Few on Wall Street had much knowledge about the internet. But, everyone intuitively understood how much leverage a company could have access to if the internet was properly harnessed.

So, while a few companies were making any profits, or even sales, investors knew that their future earning potential is virtually unlimited.

 So, the market had no idea how to value these high-risk, high-potential, pre-earnings tech companies. Because there was no accepted methodology, hype and FOMO came to rule valuations, leading to a violent downturn as the bubble popped.

 Seeing as professional money managers and analysts couldn’t figure out how to value internet stocks, how well do you think amateur investors were at evaluating uncertain future earnings growth? 

The Stars of the DotCom Boom
Henry Blodget

One of the stars of the dotcom boom was Henry Blodget. Blodget was a young analyst at Oppenheimer, a lower-tier investment bank at the time. He was mostly hired due to his youth, as banks were looking for anyone with unique insight into internet companies.

Out of mostly luck, Blodget’s first recommendation on Amazon.com’s stock was a huge success, leading to him becoming a stock market celebrity on Wall Street and Main Street. He was a frequent guest on CNBC, and retail investors heavily followed his stock picks.

 He was soon hired as the head of global internet research at Merrill Lynch in his early 30s and became the most followed analyst on Wall Street. Before the bubble, there was really no such thing as a celebrity research analyst, but the CNBCization of the market, as Brian McCullough of the Internet History Podcast called it, was turning trading into the new national pastime. 

In her book about bull market cycle that started in the 80s, Maggie Mahar described Blodget as an ordinary young guy who didn’t have any more internet wisdom than your average web user, but was catapulted into fandom due to bank’s need for internet stock picks.

She goes onto explain how, in every asset bubble, there is a non-expert propelled into expert status based on faulty criteria, and Blodget was that guy. 

Alan Greenspan

Alan Greenspan, or ‘Uncle Alan,’ as Wall Street referred to him, is often blamed for his role in allowing the market and economy to get out of hand. The 90s was the time of “Goldilocks Economy,” where inflation, interest rates, and unemployment levels were just right.

Retail and institutional investors alike revered Uncle Alan for ‘saving’ the market each time things got too out of hand.  

Greenspan became enamored with the “new economy” like the rest of the market. At one point, when productivity statistics weren’t as favorable as he believed they should be, he ordered the recollection of the data.

He firmly believed that new technology had to be improving productivity across the board, and thought the conventional calculation methods weren’t capturing the increased productivity. 

Uncle Alan became such a believer in the bull market that he did whatever he could to support and prop the market up, based on the belief that this bull market was different, that this level of technological innovation has never occurred inside such a compressed time period, and deserved the same unprecedented price movement.

 Greenspan created an environment where too much money was chasing too few assets. 

What We Can Learn From The Dotcom Bubble
Innovation Doesn’t Equal Returns

Of the several internet companies that went public during the dotcom bubble, a small handful is still around in a meaningful way: Amazon, eBay, and Priceline come to mind, with a few other smaller companies still around. 

Investors in the 1990s knew that the internet and computers were going to change the world. But, sometimes, calling a trend correctly doesn’t convert into investment returns. Those around at the start of the automobile industry probably knew cars would change the world, too, but unless they heavily weighted into Ford, GM or Chrysler, their portfolios were also crushed. 

There’s a significant Pareto distribution at play here. In a new industry like the internet, a tiny percentage of companies will ultimately succeed, and of those that do, they get a giant slice of the pie.

Investing in the Future

Most investors pay a premium for a company with massive future potential, but nothing to show for it today. This is backward, as the vast majority of companies with new, untested ideas fail. Think about how many companies have tried to enter the alternative energy space.

Outside of Tesla, can you think of any massive successes? In industries like these, losers outnumber winners big time, and you should expect that to be priced into a stock that you’re buying based only on its future potential.

 Bottom line: when investing in new, untested ideas, your price should reflect the massive risk inherent within.

Valuation Matters

A share is a claim on a company’s earnings. If a company in a new, frothy industry is trading at sky-high multiples of their earnings, the market is pricing in massive growth. But, the thing about companies within frothy sectors is that the vast majority fail in the long run.

Once the hype and momentum cool down, and the traders get off the train, the real investors are going to be expecting to see some earnings. Once the positive-feedback loop of price advancement stops, the stock usually craters.

 Even the strongest companies of the era, Amazon, Cisco, etc., were still brutally punished as the bubble burst. Once rationality set in, the buyers who survived the crash were only willing to buy proven companies that can justify their valuation. 

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Top 5 Most Famous Traders Of All Time

Finance News

In all industries there are people credited to being the best.

In design, the late Steve Jobs is credited to being the best in his industry. In boxing, Muhammad Ali was credited to being the best boxer of all time.

In U.S. politics, there is a consensus that Abraham Lincoln was the nation’s greatest President by every measure applied.

In the trading world, a number of traders are known worldwide for their skills. From Jesse Livermore to George Soros, we are sharing these tales of past and present traders who had to claw their way to the top.

Here, we will look at the five most famous traders of all time and cover a little bit about each trader and why they became so famous.

Jesse Livermore

Jesse Livermore jumped into the stock market with incredible calculations at the age of 15, amassed huge profits, then lost them all, then mastered two massive crises and came out the other side while following his own rules, earning him the nickname “The Great bear of Wall Street.”

Livermore was born in 1877 in Shrewsbury, Massachusetts.

He is remembered for his incredible risk taking, his gregarious method of reading the potential moves in the stock market, derivatives and commodities, and for sustaining vast losses as well as rising to fortune.

He began his career having run away from home by carriage to escape a life of farming that his father had planned for him, instead choosing city life and finding work posting stock quotes at Paine Webber, a Boston stockbroker.

Livermore bought his first share at 15 and earned a profit of $3.12 from $5 after teaching himself about trends.

George Soros

George Soros has an incredible backstory.

Born in Hungary in 1930 to Jewish parents, Soros survived the Holocaust and later fled the country when the Communists took power. He went on to become one of the richest men and one of the most famous philanthropists in the world.

Most day traders know him for his long and prolific career as a trader who famously “broke the Bank of England” in 1992. Soros made a huge bet against the British Pound, which earned him $1 billion in profit in just 24 hours.

Along with other currency speculators, he placed a bet against the bank’s ability to hold the line on the pound. He borrowed pounds, and then sold them, helping to push down the price of the currency on forex markets and ultimately forcing the UK to crash out of the European Exchange Rate Mechanism.

It was perhaps the quickest billion dollars anyone has ever made and one of the most famous trades ever taken, which later became known as “breaking the Bank of England”.

Soros is believed to have netted a total of about $44 billion through financial speculation. And he has used his fortune to fund thousands of human rights, democracy, health, and education projects.

Richard Dennis

There are only a handful of traders that can take a small amount of money and turn it into millions and Richard Dennis was one of them.

Known as the “Prince of the Pit”, Dennis is said to have borrowed $1,600 when he was around 23 years old and turned it into $200 million in about 10 years trading commodities. Even more interesting to note, he only traded  $400 of the $1,600.

Not only did he achieve great success as a commodities trader, he also went on to launch the famous “Turtle Traders Group”. Using mini contracts, Dennis started to trade his own account at the Mid America Commodity Exchange.

He made a profit of $100,000 in 1973. The following year, he capitalized on a runway soybean market to earn $500,000 in profits. He became an outstanding millionaire at the end of year.

However, he incurred massive losses in the Black Monday stock market crash in 1987 and the .com bubble burst in 2000.

While he is famous for making and losing a lot of money, Dennis is also famous for something else – an experiment. He and his friend William Eckhardt recruited and trained traders a handful of men and women how to trade futures. These so-called Turtle Traders went on to make profits of $175 million in 4 years, according to a former student.

Paul Tudor Jones

Paul Tudor Jones thrust into the limelight in the 80s when he successfully predicted the 1987 stock market, as shown in the riveting one hour documentary called “Trader”.

The legendary trader was born in Memphis, Tennessee in 1954. His father ran a financial and legal trade newspaper. While he was in college, he used to write articles for the newspaper under the pseudonym, “Eagle Jones”.

Jones kicked off his journey in the finance business by trading cotton. He started trading on his own following 4 years of non-trading experience, made profits from his trades but got bored, and later hired people to trade for him so he would no longer get bored.

But the trade that shot him to fame came on Black Monday in 1987, when he made an estimated $100 million even as the Dow Jones Industrial Average plunged 22%.

He became a pioneer in the area of global macro investing and was a huge player in the meteoric growth of the hedge fund industry. He is also known for betting on currencies and interest rates.

He founded his hedge fund, Tudor Investment Corp, in 1980. The fund currently has around $21 billion in assets under management and he himself has an estimated net worth of nearly $5.8 Billion.

John Paulson

Super-trader John Paulson built a personal fortune worth $4.4 billion from managing other people’s money. Born in 1955, Paulson made his name and much of his money betting an enormous amount of cash against the U.S. housing market during the global financial crisis of 2007–2008.

Paulson bought insurance against defaults by subprime mortgages before the market collapse in 2007. He netted an estimated $20 billion on the collapse of the subprime mortgage market, dubbed the greatest trade ever.

However, his track record since that bet has been patchy at best. In the years following the financial crisis, Paulson struggled to match this success.

Failed bets on gold, healthcare and pharmaceuticals stocks caused investors to flee his hedge fund Paulson & Co, cutting its assets under management to $10 billion as of January 2020 from a high of $36 billion in 2011.

Earlier this year, Paulson announced the fund would stop managing money for outside clients and turn it into a family office. He launched the fund in 1994.

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What Is The Best Strategy For Small Accounts?

Financial Advise

Most people often start to day trade with a small account and then build their bankroll and skills as time goes by.

Not only is starting out small a great way to limit your losses, it is also an excellent way of gaining the experience you need to be confident.

A small account requires you to make smarter stock selections since you don’t have as much capital to throw around. So being picky is a good thing!

But what is a good strategy for small accounts?

There is no one perfect strategy – no matter your account size.

However, we have found the bull flag pattern to be a great beginners day trading strategy that is easy to learn and identify.

Trading a small account

If you are going to be trading with a small account, you will not have a lot of room for error. Entries will be key for managing your risk so be patient and pick the best possible spots to get in.

Ensure to stay away from setups that are not A+.

Your main goal with a small account is to protect your capital and take profits when you can. It will be a grind but as you grow your account you will allow yourself more of a cushion to take more risk on.

Additionally, you have to exercise extreme patience while waiting for your setup to evolve and trigger a buy/sell signal in a small account.

Don’t just trade to trade as that will almost certainly send your account down the drain with fees and losses hurting your capital.

You also need to know when to jump out of a trade and trim your losses before they mount. That means you need to learn how you to use a stop loss order and a popular profit-taking strategies that are used by day traders.

Discipline is key no matter your account size, but it is especially important when you have limited capital.

Why stock selection and risk management is crucial

Stock selection and risk management skills are critical in trading a small account.

The market has thousands of stocks, ETFs, and mutual funds that you could trade. Traders have to pick between 5 to 10 stocks worth trading daily, and maintain a decent accuracy of winners versus losers in order to make profit.

They do this by looking for stocks that have big upside potential. Almost every single day, there is always at least one stock makes a 20-30% intraday move. These are the types of stocks professional day traders love.

To get a piece of the action, traders usually jump into these stocks as soon as one of them starts popping up. Keep in mind that the stock market runs on crowd mentality and rumors, so when a stock begins to make a move, other traders get on the bandwagon.

However, it’s important to remind everyone that just because some experienced traders can make stock selection easy, it does not mean profitability is easy.

Trading is difficult, and it requires quite a lot of dedication to make consistent profits.

Bull flag pattern

While there is no bullet proof strategy no matter the account size, we favor the bull flag pattern for trading a small account, due to its low risk entry points with potential big winners.

A bull flag is a chart pattern that forms when a stock is in a strong uptrend. The reason why it is called a flag pattern is because when it forms on a chart, it looks like a flag on a pole and since we are in an uptrend it is considered a bullish flag.

Typically, a bull flag pattern has the following features:

  • Stock has made a strong move up on high relative volume, forming the pole.
  • The price of the stock consolidates near the top of the pole on lighter volume, forming the flag.
  • Stock breaks out of consolidation pattern on high relative volume to continue the trend.
Bull flag chart pattern
How to trade the bull flag pattern with limited capital

Bull flag patterns are an excellent setup for traders with small accounts or limited capital because they are easy to identify once you understand what to look for.

Like most patterns, volume must be present on the breakout. This confirms the pattern and increases the likelihood that the breakout will be successful.

Here is a checklist for trading bull flag patterns after identifying one:

  • Stock is moving up on high relative volume, preferably from a news catalyst like earnings or CEO resignation.
  • Stock consolidates at or near highs with a defined pullback pattern.
  • Buy when the stock breaks out above the consolidation pattern on high volume.
  • Place a stop order below bottom of consolidation pattern.
  • Your profit target ought to be at least 2:1 risk/reward. Therefore, if you are risking 30 cents, then first profit target is 60 cents from your entry price.

Trading the bull flag is pretty straightforward and strategy that any aspiring trader can learn.

The challenging part of trading this pattern is spotting it in real-time.

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Reddit Strikes Again: Explaining The Recent Reddit Rally in Wendy’s

Finance News
Reddit did it again.

You can’t be blamed for thinking that the short squeezes in January 2021 were a complete anomaly, not to be repeated.

Market pundits have plenty of explanations for why, but it happened again. Last time, the main event was GameStop (GME), and this time it was (is?) AMC Entertainment (AMC). 

Let’s take a brief look at some of the biggest moves in this “Reddit group.”:

  • AMC Entertainment (AMC)
  • GameStop (GME)
  • Clover Health (CLOV)
  • Wendy’s (WEN)
  • World Wrestling Entertainment (WWE)
  • Workhorse Group (WKHS)
  • Virgin Galactic (SPCE)
  • Bed Bath and Beyond (BBBY)

 In short, the high short interest names like GameStop (GME), AMC Entertainment (AMC), and Bed Bath and Beyond (BBBY) went parabolic again, as they did in January 2021, with some newcomers this time around.

It’s not certain that these are full-on short squeezes, because a large portion of the short interest in these stocks have shored up since January, and many of the companies have issued more shares, loosening up the float.

Instead, it seems that the power of Reddit and social media-driven rallies has increased, as they even set their aims on more difficult targets like World Wrestling Entertainment (WWE) and Wendy’s (WEN), neither of which are typically thought of as “fast money” stocks. 

Many refer to the stock market in metaphysical terms now.

You’ll hear phrases like “whatever the market should do, it’s doing the opposite.” Options trader  Cem Karsan says summer 2021 will be the “Summer of George,” a reference to the episode of Seinfeld when George Costanza does everything wrong and somehow it all works out. 

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How To Draw Fibonacci Levels?

Financial Advise

If you are an active day trader, you are probably aware that Fibonacci retracement and extension levels are some of the most important and useful tools in all of price action.

Day traders and technical analysts can use Fibonacci levels analysis to confirm an entry-level, target a take profit, and to determine your stop loss level.

In this guide we will explain exactly how to draw Fibonacci levels, so that you can make better decisions about when to get in and out of trades.

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A Beginners Guide to Investment Factors

Financial Advise
Value, Momentum, Size, Low-Volatility, and Quality

Investment factors are a set of quantitative criteria used to explain investment returns.

The idea is that some baskets of securities that have similar criteria might deliver superior risk-adjusted returns. 

At its simplest, an investment factor is a characteristic of a security that is associated with superior risk-adjusted returns. That could be a low valuation, price momentum, earnings growth, insider buying, etc.

While there’s hundreds of different investment factors published in academic literature, the factors that get the most attention, have the most institutional support, and the most scalability, are value, momentum, size, low-volatility, and quality. 

Why Factor Investing?

Factor investing in many ways is a solution for investors that can’t stomach a purely passive indexing approach.

They don’t like that they’re blindly investing in hundreds of companies based on the notion that the market always goes up over time, but they’re also aware of the flaws of picking individual stocks or timing the market.

Investing in factors that make sense to the investor can be a good compromise here.

For example, you might have a strong belief in the value investing philosophy, that you should always strive to buy a business at the right price.

You could opt to invest a large portion of your equity allocation in value factor EFTs for mutual funds with the peace of mind that, even though you don’t know what you own specifically, at least you know that you own lower valuation companies. 

Essentially, a factor investment portfolio is built using simple quantitative criteria.

For value stocks it’d be ranking a universe of stocks based on a valuation metric.

For momentum, it might be a 12-month lookback at returns. Of course, factor investors optimize and have more sophisticated models, but the big ideas are simple and laid out in this article. 

The Value Factor

The value factor represents the historical tendency for stocks with low valuation to earn excess returns compared to both the overall market, and their high valuation counterparts.

How do you define a low valuation, though? A few decades ago, a 20 PE was very high, while today it’s the market average. 

This is why factor-based strategies employ a relative valuation approach.

They buy what’s cheap compared to the rest of the market, rather than setting an arbitrary hurdle rate for their investments. This prevents factor-based strategies from taking a specific macro view on what risk premiums should be or will be.

The Momentum Factor

The momentum factor refers to the tendency for recent outperforming stocks to continue their outperformance in the short-to-medium term.

You can sum this up as “buy what’s going up, sell what’s going down.” And the interesting thing is that most equity momentum models that hedge funds charge fees for are no more complex than that. 

Momentum has always been the red-headed step child when it comes to sources of returns.

Sophisticated investors look down on it and deride them as gamblers or market tourists without skill. I’d say this is more Wall Street culture than anything. Simple solutions are hard to sell because clients can implement them on their own. And most Wall Street executives are Harvard or Wharton educated, and can’t imagine a naive strategy of buying the stocks that go up would ever work. 

But, there’s substantial evidence in favor of the momentum factor providing excess returns. It’s well accepted by both academia and institutional investors alike.

The basic way that a factor-based equity momentum portfolio works is, you rank the universe based on trailing six or twelve month performance, and buy the top performers. There’s some extra algebra involved, but that’s the core essence of it.

The Quality Factor

The quality factor refers to the tendency for firms with high levels of profits to outperform unprofitable firms. Like the other factors, there’s multiple ways that factor investors might express quality, and there’s not really an agreed upon definition for “quality.”

Between ETF managers, academics, and hedge funds like AQR, everyone has their own definition of the quality factor. But there’s tons of overlap. Here are some metrics you’ll see in a lot of quality models: 

  • Return on invested capital (ROIC)
  • Return on assets (ROA)
  • Gross profits
  • Inventory turnover
  • Return on equity (ROE) 

As you could probably make out, these metrics are all screening for companies that take money and turn it into more money in an efficient and fast way, with few surprises.

One example of a quality factor model might be to use a weighted average of a few of the above metrics to prevent the risk of an anomaly in a company’s financial statements from ending up in the portfolio.

The Low-Volatility Factor

The low volatility factor refers to the tendency for boring stocks to outperform their high-flying, exciting peers in the long-term, on a risk-adjusted basis. Of all five of the major factors, low-volatility is the least explainable.

The rest makes sense and could be explained to a five-year old, “buy what goes up,” “buy the bargain bin,” “buy the top-shelf goods,” “buy the underdogs.” 

Because of the lack of explainability, there’s a higher potential that the outperformance is an anomaly or the result of data mining. The low-volatility factor flies in the face of the Capital Asset Pricing Model, which posits that investors should be compensated for taking on more risk. But, this factor says that the returns are actually higher in the lower risk assets.

Building a low-volatility portfolio would be relatively easy. You can use the stock’s N-day standard deviation, its average true range, or even it’s Beta. Then simply rank and buy the lowest volatility stocks.

Building a long/short portfolio for this factor seems like a disaster waiting to happen, though. 

The Size Factor

The size factor refers to the tendency for smaller stocks to outperform large stocks.

This is probably because with small and micro cap stocks being generally illiquid, an investor deserves a risk premium for taking on the liquidity risk.

Further, it’s much easier to double $100 million of revenue than to double $10 billion of revenue, making the potential for home runs with small stocks much higher. Also, small stocks receive very little Wall Street coverage, and most institutional investors are too big to pay attention to them, leaving alpha on the table. 

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