Financial reporters use the term “parabolic” to describe the behavior of a stock – and occasionally the market in general – whose value has risen dramatically in a short period of time. As a general rule, investors should treat these reports as caveats.
News about a company can often quickly propel its stock price higher as new investors and traders of the day jump on the bandwagon. After the initial burst of excitement, the price may drop for a few days before starting to climb steadily again. Patient investors who invest long-term tend to research the company first before buying to see if recent development improves the fundamentals of their company.
This is not the case in a parabolic situation. What happens is that the stock price just keeps climbing relentlessly as more and more investors create what appears to be an endless cycle of higher prices each trading day. The daily chart will adopt the characteristic of an exponential curve that appears vertical in its pattern.
Each trading day, more investors buy shares in the company. This increased demand tends to create large upward differences in price. The process can continue for several weeks as the stock price first doubles, then triples, and so on, until the valuation far exceeds the usual parameters investors use to evaluate a company’s stock.
But no one seems concerned that the stock price continues to rise. Confidence of hysterical proportions develops in the minds of investors, who seem convinced that the stock price will simply continue to climb endlessly.
These situations invariably end with the same result. One day, usually during the middle of the session, the price reaches a peak and then begins to decline. At first, it seems that one day traders are making quick profits of a few points. Because sentiment is so high, investors are expecting the meteoric rise to resume. But the price keeps dropping.
At this point, the panic buy is reversed to become a panic sell. Then the price starts to drop dramatically for the remainder of the session, opens lower the next day and continues its decline almost as fast as it rose. Early buyers can still walk away with a sizeable profit, but late-arriving buyers who simply saw a small drop as a temporary setback often end up selling their shares at a large loss.
The parabolic situation can be compared to the growth of bacteria in a culture dish. These organisms divide repeatedly as the total population increases exponentially. A single organism becomes two. These two split to become four. Those four divide to become eight. The total population on the plate expands rapidly until thousands, perhaps millions, of single-celled organisms grow and divide.
Then the nutrient that the bacteria were feeding on in the dish runs out. In the case of a stock whose price has increased exponentially, it is a matter of not showing more buyers willing to pay even higher prices. The result on the culture plate is mass death and a stock price crash.
Whenever an investor hears or reads the word “parabolic” attributed to a stock, they should regard it as an emptor warning situation, or “let the buyer beware.” If you decide to take a stock position, it must first be understood that there is a high degree of risk associated with such a decision. If the investor is not in a position to monitor the stock price constantly, the best course of action is to avoid it altogether.
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