There is only one rule to making money in any investment: BUY LOW, SELL HIGH. Sure, there are dividends and stuff like that, but at the end of the day, making money means selling at a higher price than you bought at. Of course, HOW to do that is more complicated than just making the statement. But lucky for you, we have an amazing stock market analogy to help you make sense of it.
Now determining what is high and what is low is the difficult part, but it doesn’t have to be so complicated that you have to be a Wall Street trader to understand it. Let me give you a simple analogy:
A Stock Market Analogy
You go to the store to buy fruit because you know that eating it is good for you. Now you want at least three different kinds of fruit for some variety, but the theme is fruit, not necessarily what kind. When you go to the store you see the following prices:
Bananas………………33¢ per pound
Grapes…………………$1.48 per pound
Apples…………………79¢ per pound
Apricots………………98¢ per pound
Nectarines…………….$1.18 per pound
Strawberries…………..99¢ per pound
What Do You Buy?
If you are operating on a buy low sell high mentality in our little stock market analogy, I suspect you would naturally buy bananas, apples, and apricots because they are the cheapest, right? That would make the most sense considering that your purpose is simply to get fruit. Why not the cheapest? Now suppose the following week you are back at the store and prices have changed a little:
Bananas………………43¢ per pound
Apples……………….99¢ per pound
Apricots………………88¢ per pound
Nectarines……………$1.28 per pound
Strawberries………….89¢ per pound
NOW What Do You Buy?
This time of course you will buy bananas again, as well as apricots and strawberries. Hopefully you wouldn’t buy more expensive fruit just because it looked neat or your brother’s sister’s neighbor told you it was a “sure thing”. Yet many people buy stocks for those very reasons. The stock might not be a bad play, but more often than not, it is. In the investment world, if everyone’s doing it, you’ve probably already missed the boat. You want to find it low BEFORE it goes up and sell when everyone is raving about it.
What Our Stock Market Analogy Means
In our fruity stock market analogy, we compared various fruit prices to each other, but when it comes to stocks, the best picture of a particular stock comes from comparing it to itself. So let’s change our analogy a little bit and pretend that your favorite fruit is bananas, but you don’t want to overpay for them. In other words, you won’t buy them unless they are a good deal. So you start charting their price each week and you get the following graph:
Looking at the last 24 weeks of banana prices, it seems that their value ranges from about 25¢ to 70¢. You could also say that a good or low price for bananas is anything under 40¢ per pound and anything over 50¢ is a little high. So you decide to only pay 40¢ or less for bananas. Why? Because you will get the best value that way. If bananas never spoiled, you might also conclude that when the price goes below 40¢, it is time to stock up. That way, you won’t have to pay higher prices later and you can still have bananas when they go up in price.
Now let’s change our stock market analogy slightly and pretend that you are a banana salesman. When would you buy bananas and when would you sell them? Since you can’t guarantee they will get down to 25¢ again, you may decide to buy tons of bananas whenever they get below 35¢, knowing that even if they go lower, it shouldn’t take long for them to go over 40¢.
Ideally you would sell them when they got close to 70¢ again, but you can’t be sure they will. You can be fairly certain that they will go over 40¢ again though. So you may not buy at the lowest and sell at the highest, but you will still make some good money if you buy below 40¢ and sell over 50¢. But this is better than waiting for a 25¢ low or a 70¢ high because, based on its past performance you may never see those prices again.
Digging Deaper Into Our Fruit Story
Now let’s continue to follow this scenario and look at the price between weeks 14 and 15 where the price is below 40¢, but it falls even farther to 25¢. What do you do? This is not a trick question; the answer is that you would buy below 40¢ and then buy even more when the price went lower yet because it is almost a certainty that the price will go back up. At this point, your average purchase price would be much less than 40¢. So when it is finally time to sell, you will make even more money.
Now if you are an “average” banana salesman, you would freak out when bananas fell below 30¢ and sell them for 25¢ over concern that the price would fall even farther, effectively losing something like 15¢ per pound of bananas. Then you would feel really stupid when the price went right back up to 50¢. By the way, this is what guys who don’t know about this website do all the time.Then they tell you that the stock market is a “gamble.”
You Should Trade Stocks the Same Way!
I hope this stock market analogy has subtly implanted in your brain some things you probably already knew, but run contrary to conventional ‘buy and hold forever’ wisdom. The so-called pros tell you to dollar-cost-average, which states that you find a good investment and just keep investing in it regardless of the price. But what if you could buy ONLY when the stock was low and sell ONLY when it was high? You would make A LOT more money than if you just blindly bought stock no matter what the price. Now I’m certainly not implying that it is easy to determine when a stock is at it’s lowest or it’s highest. God only knows that. But what I am telling you is that it isn’t hard to tell when a stock is “relatively” low or high. That’s all you need to know to make money.
Synopsis of Lessons Learned
Charts are your most powerful tool in determining if a stock is high or low. Careful examination will help you to determine what you feel confident would be a buy point, and what would be a sell point. Keep in mind though, that the more “stable” the company, the more effective this approach can be. By “stable,” I mean companies that are big enough to avoid huge swings in price. Typically these are stocks that are at least $10 per share and at least $1M per day in dollar volume. Dollar volume can be determined by multiplying the price per share times the number of shares traded for the day. For instance, if the number of shares bought and sold (referred to as volume) is 400,000 and the share price is $50, then the dollar volume is 400,000*$50= $20,000,000.
A stock’s highs and lows are intimately connected to the amount of time you are looking at. For example, the high for bananas for 24 weeks is 70¢, the low is 25¢. For the first 12 weeks, the price stays between 30¢ and 60¢ the whole time. In other words, what is high and low depends on the amount of time you are looking at. The longer the amount of time , the more reliable the data for future projections, but the longer you are likely to wait to reach a selling point. Also, you should expect your “high” and “low” determination to only be good for the length of time you are looking at. For instance, if the “high” for 1 year is $20, don’t expect to buy at $10 and see $20 in two months.
If you consider less than 40¢ for bananas to be a low, wouldn’t you rather pay 30¢ or even 25¢? Of course you would! With stocks, if you buy in at a “low,” but it goes even lower, buying more will only INCREASE the profits you are already confident you will make. Conventional wisdom teaches you to sell at a loss if your investment doesn’t move like you expected. But why not buy more instead of hoping your next investment isn’t a flop as well? This is contrary to what the financial world would have you believe. However, it is a powerful tool in making money in stocks.