Investors want to purchase stocks at a low price and sell them at a high price. This is what we have all heard from the first time we were exposed to the financial markets. The biggest issue facing investors is: ‘What is low and what is high?’
There are many schools of thought that attempt to tackle this issue, which can make it very confusing for the average investor. Traders need to simplify the process of stock selection and identifying proper entries and exit points in order to increase the probability for better trading.
Online Trading Academy’s Core Strategy methodology could be used to find the proper entry and exit points once a trader has figured out what stocks to trade. Again, there are many avenues that could be taken but I believe that one of the best is likely to be one of the oldest.
Most traders and investors are familiar with the name Warren Buffett. However, they may not know who Mr. Buffett’s mentor was. That gentleman was Benjamin Graham, and he is the father of value investing.
What is Value Investing?
Value investing is a relatively simple strategy for purchasing stocks when they are under their value by a significant margin. There are several key things to being proficient in this type of investing, the first is being able to buy when markets and/or stocks are depressed.
Most people are reluctant to let go of their stocks when markets are crashing and are therefore stuck holding and hoping prices return to previous glory. We need to be realistic in the markets. They go up and down. Taking a small loss is much better than a large loss and is not a problem because it allows you to preserve your capital for when the markets bottom out, presenting potential buying opportunities.
This is important to remember with the major bull markets we have been in as of late, because the markets will crash again sometime. When they do, this is when value investors see opportunities.
How to Estimate the Value of a Stock
Another key element to being able to identify the right stocks to buy is being able to correctly estimate the value of the stock. This value is called intrinsic value and it is not the same as the market price you see online.
Markets are inefficient and will often rally due to irrational emotional response from eager investors. This will cause individual stock prices to rise well above their intrinsic value as people chase their favorite stocks.
In contrast, when the markets begin to drop the panic sets in and the pendulum swings the other way. The ensuing rush to sell, causing market crashes or even simple corrections, can cause stock prices to drop well below their intrinsic value. This is where the value investors seize their opportunities.
Margin of Safety
Value investors want to buy stocks when they are trading well below their intrinsic value. The difference in price at which they buy in the market versus the intrinsic value is called the Margin of Safety (MOS). The larger the MOS, the better off the value investor is, even if they estimated the intrinsic value incorrectly.
Let’s say, for instance, that stock ABC has an estimated intrinsic value of $67 per share. If a value investor buys the stock at a price of $36 per share, they are buying at a price that is less than 55% of the intrinsic value, this is the MOS. Prices should rise at least to the intrinsic value, so the investor has a high probability of profiting from their purchase.
But what if the estimated intrinsic value is wrong? For example, perhaps the intrinsic value was really $52 instead of $67. Estimating an intrinsic value can be tricky and is not exact, that is why we need a margin of safety. The new MOS for our example is 30%. While this is not as great as a potential profit, it is still an opportunity with relatively low risk if purchased at a demand zone. If the MOS is too small, the value investor runs the risk of paying too much for the stock and not benefiting from the subsequent rise. There needs to be a great value before purchasing, not just a value.
There are a lot of ratios and calculations that need to be done to ensure you are investing properly. Combine this with learning how to apply the entry and exit rules from Online Trading Academy’s Core Strategy and you could have a rule-based strategy to help you confidently navigate investing in the stock market.
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