This year for stock investing may have been bumpy, when everyone markets crashed and they left a lot of sore wallets. But let's be realistic. It is difficult to know when prices have reached their lowest point, and even more difficult to know how to move in these situations to generate profits. So today we bring you three strategies that will help you detect the market bottom in your stock investment, even if you don't know exactly when it will arrive.
Strategy 1: Enter the market gradually
The first strategy is based on gradually increasing our investment in stocks as prices fall. In this way we will reduce our average entry price and maximize our long-term profits. There are different ways to increase our investment in stocks as prices fall. Let's say we want to make a total investment of $500. If we have the perception that the market is close to hitting bottom, we could buy $300 now, $100 when it reaches a predefined lower level, and another $100 below. The fall could probably be further along. We could start with 100 dollars and gradually buy between 150 and 250 dollars each time the prices reach a lower level. If we don't have a strong opinion, we could buy $100 and then an equal amount at the four lowest price levels.
Comparison of buying once vs buying with the average cost. Source: SDT Planning
Of course, the process of gradually building larger positions as prices fall will minimize our average entry price, but it also makes it more likely that we will not be fully invested if a rally materializes. The decision on how to apply this strategy therefore depends on how you feel about this trade-off.
What are the pros and cons of this strategy?️
This strategy has a direct and mechanical approach, and each level we can easily define in advance with “buy limit orders”, an order to buy an asset at a specific price or better. Furthermore, it will not only force us to develop an action plan, but to respect it, reducing the impact of our emotions. Furthermore, if prices continue to fall before recovering, we will have entered at a much more attractive average price, which could increase our long-term profitability quite significantly (the power of compounding is quite magical over a long horizon).
Example of the average purchase price strategy. Source: OKX
The main drawback is that we have to select at what price we will buy and in what quantity. And it's a delicate balance: if we invest too little too late, we could give up much of the profits if prices recover sooner than expected, but if we invest too early, we will remain exposed if stock investment prices they fall much more.
Strategy 2: Follow price momentum
The following strategy is based on following the price momentum of the stock investment. We can use the "improved momentum" indicator, which allows us to observe whether the current price of the stock investment is higher than that of four, eight months ago. months and 12 months. If the answer is affirmative more than once, we can say that the price shows positive momentum, making it the ideal time to make our investment in shares. If the answer is no, we should stay away or go short.
With the price momentum following strategy, we can generate profits on our stock investment. Source: Finbold
Of course, we can trade with different time periods by reducing or adding more of them, expanding or reducing (the shorter the period, the more reactive the indicator will be to small bounces), or even, say, buying as soon as the price current price exceeds its historical price in only one of the periods.
What are the pros and cons?
As with the first strategy, this one will improve your chances of making the right, albeit difficult, decisions. You never really know how far the markets can go, and relying on an indicator to tell us when to get back in means that we are much more likely to be out of the market for most of the fall, especially if it is It is important.
Comparison between impulse reversal, without overlap and with overlap. Source: Klementon Investing.
The main drawback is that this indicator is especially exposed to false rallies: when prices rise and trigger a buy signal, before reversing and falling again. Furthermore, Momentum is a lagging indicator, which means it will always give a buy signal after prices have started to recover and we will never invest exactly at the bottom.
Strategy 3: Buy options
The easiest way to benefit from a possible rebound is to buy call options. If prices recover, we can make big profits. And if prices fall, our loss is limited to the premium paid for the option. Of course, that premium rises based on volatility, which is likely to be greatest if the option is purchased when prices are falling. Therefore, even if we are right and prices recover, the high option premium will offset some of our profits. Fortunately, we have ways to limit our exposure to volatility and reduce the premium paid for the option. The first is to implement a «bull call spread", which consists of buying a call option and selling another at a higher "exercise price", that is, the price at which one has the right to sell. The only problem with this is that, although we reduce its cost, we also reduce its advantage. The call option we have sold will limit our profits if prices rise above our highest strike price.
Example of the Bull Call Spread strategy. Source: Fidelity Investments
If you want more aggressive exposure to a bounce, the 1×2 purchase ratio spread It is a really interesting option. It offers us a way to benefit from a strong rebound at zero cost. That is, if stock investment prices fall, we lose nothing, and if prices rise a lot, we benefit a lot. The downside is that we can lose some money (although it is a limited amount) if prices only rise by a small percentage. This means that this operation is only suitable if you believe that the prices of the investment in shares are going to fall much more, or that they are going to rebound strongly.
Example of the 1×2 purchasing ratio differential strategy. Source: Fidelity Investments
What are the pros and cons?
The main advantage of the options strategies that we have analyzed is that we have an asymmetric profile. We will have full upside exposure while limiting our losses in case we are wrong. Of course, the main disadvantage is that you pay for that option in one way or another. It can be through a higher premium in the case of the call option, through a limited increase for the bullish spread, or through of a loss if prices rise slightly in the case of the 1x2 buy ratio spread. Furthermore, they are not as easy to apply and manage, so they are only appropriate for more experienced investors. In this way, we will be able to cover the possible losses that our stock investment portfolios may suffer when the market falls.