Introduction
After months of meticulous research on a promising company, you’ve studied its stock chart repeatedly, searching for the perfect entry point. As the price climbs, hesitation gives way to anxiety. The fear of missing out (“FOMO”) takes hold. Convinced that this is the opportunity that could redefine your financial future, you finally make your move, loading up your brokerage account and executing a market order.
The next day, the stock surges again. Confidence soars. It feels as if the stars have aligned. But just as quickly, momentum shifts. Two days later, the stock retraces back to your entry price. Analysts reassure investors that this is a temporary pullback. Some say this is the real buying opportunity. Then comes a 2% decline. And another. Doubt creeps in. Why aren’t more people buying at this “discounted” price?
This familiar scenario illustrates the psychological trap many investors face when chasing momentum. The allure of a skyrocketing stock can override caution, leading to emotional decision making that often results in buying at the peak. It’s a cycle that has played out time and again in financial markets, serving as a stark reminder: in investing, patience and discipline often outperform emotion-driven urgency.
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Abstract
Trading is as much a psychological battle as it is a financial endeavor. It tests your perception of yourself, the market, and those around you. One of the most critical aspects of long-term success as a trader or investor is understanding the fundamental balance between risk and reward. In 2019, the stock market underwent a significant shift, ushering in a wave of retail investors. Following the momentum of the 2018 "Weed Craze" rallies, market dynamics evolved rapidly, requiring traders to adapt to new conditions. As Leo Tolstoy famously said, “The two most powerful warriors are patience and time.”. This article will explore key methodologies, mindsets, and tools that have helped me navigate risk and exposure during periods of uncertainty, offering insights into staying disciplined and strategic in ever-changing market conditions.
Moving Averages
“What are those lines on the chart?” is a question I frequently hear when analyzing stocks in public. I usually respond by explaining that they’re moving averages, a fundamental tool in trading. Like many traders, I take the time to break it down for the curious bystander who, in reality, may not care much. After about ten minutes of enthusiastic explanation, I often glance over to see their glazed eyes, realizing I lost them right after saying “moving.”
At its core, a Simple Moving Average (SMA) is just that: simple. It represents the average closing price of a stock over a specified period. For example, calculating the 50-day SMA involves summing the last 50 closing prices of a stock and dividing by 50.
An Exponential Moving Average (EMA) follows the same principle but with one key difference: it gives greater weight to more recent prices. This makes the EMA more responsive to current market movements. For instance, in a 50-day EMA, yesterday’s closing price has a larger influence than the price from several weeks ago.
Below is a chart of SPY, featuring four moving averages (MAs). For this analysis, we will focus on two key indicators:
The Purple Line: Represents the 50-day simple moving average (50SMA)
The Blue Line: Represents the 200-day simple moving average (200SMA)
Two key observations I’d like to highlight are the price's tendency to revert to and align around the 50-day simple moving average (50SMA), with appropriate fluctuations above and below this level, followed by periods of cooling back to the average. This behavior allows for price to climb gradually into larger returns without introducing excessive volatility or the risk of a sharp, downward move.
It's a healthy practice to observe how price, driven by buyers and sellers interacts with key historical averages like the 50SMA and 200SMA. Today, we’ve witnessed one of the first drops to the 200SMA in 18 months. Notice the price reaction: sellers driving it lower, while buyers exert pressure as the price approaches the 200-day average, as indicated by the wick.
While it's still early in the trading session and I believe this move lower has more room to run, it's critical to understand how price will behave around these levels. Much of this movement is influenced by two other factors: fair value and premium, which play a significant role in market dynamics.
Fair Value
Fair value in trading represents an asset's estimated intrinsic worth, derived from fundamental and market-related factors rather than its current market price. Similar to moving averages, fair value serves as a tool for assessing whether an asset is overvalued, undervalued, or fairly priced.
Consider the following example. The chart below compares the price of SPY with its adjusted (operating) earnings. The two key lines to focus on are:
The Orange Line (with Triangle markers): Represents the fair value of SPY.
The Black Line: Represents the actual market price of SPY.
A key observation from this comparison is the associated risk. When the market price (black line) significantly diverges above fair value (orange line), it suggests that speculation and market exuberance have driven extraordinary gains. However, this also indicates heightened downside risk. If market sentiment shifts, the price may revert to fair value, as seen during major market corrections such as the 2008 financial crisis, the 2018 “flash crash,” and the 2020 “COVID crash.” These instances demonstrate how the black line historically retraces back to meet the orange line, highlighting moments of both risk and opportunity.
This valuation approach is applicable to any publicly traded company, with greater historical data providing more reliable trend insights. By understanding fair value, traders and investors can better assess market conditions and make informed decisions.
Premiums
Premium refers to the amount by which an asset’s market price exceeds a reference value, such as its fair value, intrinsic value, or offering price. This premium can signal investor confidence, market speculation, or external factors driving demand. Important to note that a stock trading at a premium is not necessarily overpriced. It may reflect strong growth potential as seen many times throughout history with names like NVDA, TSLA, etc. However, an excessive premium can also indicate speculation, increasing downside risk if the stock reverts to fair value. Think of names like UPST, ROKU, etc.
Using the same chart as before, we now focus on a different set of indicators. The chart below compares the price of SPY with its adjusted (operating) earnings, but the two key lines to observe are:
The Blue Line: Represents the Normal P/E ratio
The Black Line: Represents the actual market price of SPY
The Normal P/E ratio represents the historical price-to-earnings multiple at which the market has typically valued the company over time. It is calculated as a trimmed average of annual P/E values over the period shown in the graph.
Notably, when the price (black line) exceeds the Normal P/E ratio (blue line), a reversion to the mean often follows. This occurs because, during market corrections, premiums tend to contract as investors reposition toward historically justified valuation levels, reducing risk.
The relationship between price and the Normal P/E ratio serves as a valuable tool for assessing risk and timing market entries and exits:
If the market price is well above the Normal P/E ratio, it may indicate an overextended premium, suggesting a potential correction ahead. Traders might consider reducing exposure or waiting for a better entry point.
If the market price is below the Normal P/E ratio, it could signal an undervaluation, presenting a potential buying opportunity.
By analyzing premiums in this manner, traders and investors can make more informed decisions, balancing risk and reward effectively.
Conclusion
It's easy to get caught up in the hype of a market rally, where the allure of potential gains and the dream of making the perfect trade can cloud judgment. This reaction is completely understandable, as it's a natural tendency of the human psyche. This article was written today in light of the market reversal we’ve seen over the past week, particularly triggered by NVIDIA's earnings, which have raised concerns about softness and the growing risks to future returns.
Understanding risk and investor sentiment during times like these is essential for standing out and positioning yourself ahead of the market. While it's impossible to time everything perfectly, you can gain a deeper understanding of why price behaves in certain patterns and how it operates more consistently within those patterns.
I recall my first summer back from college, when I decided to dive into trading and active investing. My dad had worked on Wall Street in the '70s and '80s, and during that summer, we worked on various projects around the house such as painting trim, building a porch, organizing the garage, and so on. During lunch breaks, we would talk about the stock market, as I told him I wanted to use the time to learn as much as I could from his experience.
The first words he shared in those sessions were: "Pigs get fed, hogs get slaughtered."
