Zoom Technology Case Study
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Hi everyone, those who follow the channel will know I’m not a fan of the buy and hold approach for singular stocks, although holding Indexes, ETF’s and other diversified funds for the long term can be a viable approach.
In the video we look at an example of a popular stock which would have made it into the hands of the long-term investor, but with a disappointing ending.
We not only look at the behavioural aspect of the chart but we also look at metrics such as Return On Risk and the impact of leverage.
Let’s look at the stock; Zoom Video Communications. Zoom became very popular during the pandemic, making it easy for people working from home to communicate. This new found popularity soon became reflected in the stock price, and we can see here just how much the stock increased by.
From February 2020 the Zoom stock price moved from approximately $90 all the way up to a high of $590 in a matter of just 36 weeks, an increase of over 550%. However the stock price soon recalibrated over the next 18 months and has since returned back down to pre pandemic levels.
Here lies the issue with buy and hold; during the 18 months since the all-time high, not only did the long term investor endure a huge decline, but they suffered from opportunity cost, the cost of having their capital locked up, thereby losing any opportunity to invest in anything else during that time.
Before we look at the alternative method, let’s look at how and why examples like this are frequently seen in the market.
Price charts are highly correlated to the behaviours and psychology of the individual, after all, prices are moved by the buying and selling action of everyone involved.
The theory represents the action of a bubble and can be seen across many different assets, not just stocks. Ultimately the profile is driven by investor enthusiasm, which eventually leads to greed, followed by denial, fear, and eventual capitulation.
Within the chart we can also categorise the individual groups. For example, here we call the region Smart Money, where smart investors identify a change in economic fundamentals.
Here we have the Institutional Investors, usually banks and hedge funds slowly accumulating positions. Next we have the general public, this group are often sucked into the hype and enthusiasm, and to compound matters, many of the investors forming part of this group, often buy at the top and sell at the bottom, whereas the smart, sell at the top and buy at the bottom.
The question is, how do you become part of this group, and not this group?
With this theory in mind, let’s move back to the Zoom stock chart.
The Smart investors would have started to invest here just as price started to move out of its base. Institutions would have started to build positions here, and the general public here, also known as the euphoric phase.
The same sequence would also happen during the selling process, the Smart investors would perhaps exit here, the Institutions would start offloading their stock here, and the public would either sell or hold on to their positions sometime after.
Let’s look at the extreme case in terms of returns between Smart money and the public before we move on to my approach.
In the first two groups we will estimate buy price and sale price, this will clearly be subjective but will be a typical gauge for comparison.
Let’s assume the average buy price for the smart investor was here at 107 just as the price started to make a clear move above the 20-week moving average, whilst the average sell price was here at 460 after a clear change in momentum. This would provide a great return of approximately 430%.
It is also assumed that this smart investor, much like a buy and hold investor, did not use a stop loss, therefore the positional risk was 100%. If we divide the 100% positional risk by the return of 430%, we get a Return on Risk ratio of 1 to 4.3.
Next we look at a typical investor from the public, we assume an average buy point here whilst enthusiasm is rising, for an average price of perhaps 320. The typical investor will keep holding the position despite the fall in price, in denial whilst hoping the price turns back up. The price continues to fall, first fear sets in soon to be followed by panic and eventual stock price capitulation. The investor either sells at the low or merely hangs on in the hope that he will eventually be right.
At the current price of 107 we get a negative return of 66%.
Once again we make the assumption that the general public, whom often class themselves as long term investors, do not use stop losses, therefore 100% of their position is at risk, meaning that we get a Return on Risk ratio of 1 to 0.66, clearly not a sustainable proposition.
Can you see that even by using the same stock the outcomes are completely different, the smart money is risking one dollar to make just over four dollars and the dumb money is risking one dollar to lose over half a dollar.
Now, let me show you how you can improve further on the smart money returns with my approach. This will give you the basic concept of my strategy that I use and teach without the intricacies, but if you want to learn more you can always join our group or download the PDF.
Ok, let’s look at my approach and compare it with the others.
The first thing I look for on the weekly chart, is lateral consolidation, closely followed by a breakout.
Notice how price moved laterally without huge volatility for over 16 weeks. This contraction of volatility is like a compression cylinder, and with the right catalyst it can result in a big move, the catalyst in this instance was the pandemic and the demand for the zoom product.
Price soon moved above the 20-week moving average line, indicating a positive trend, whilst the blue mack dee line also rose above the signal line. I watch both the 20-week moving average and mack dee indicators closely.
My entry point would be at the break of consolidation, but before entering the trade we need to determine our risk, we need a stake in the ground which defines a price point in which we must close the position, this is the key divide between smart and dumb money versus my approach.
I would place a stop loss order somewhere in consolidation, and for ease of calculation we will assume it to be 10% of position size, therefore should price fall back into consolidation instead of continuing its trajectory upward we would lose a maximum 10% of the trade, instead of all our money should the stock immediately capitulate.
So, so far we identified consolidation, saw a breakout based on a reasonable narrative, which took price above the 20 week moving average in alignment to the positive mack dee, and we defined our risk. Next we need a rule to exit the position.
There are a few trains of thought when exiting a position, you could sell into strength, sell at the first sign of trouble, or my approach which is the confirmation that the trend has in fact changed direction.
There are a number of ways to suggest a change in trend, again I rely on either the 20-week moving average line, the mack dee, or a combination of both.
In this example we will assume the crossing of the mack dee line to be the signal to close the position. Without being to precise let’s assume we sell in this area, just after the mack dee line crossed down.
We can now look at the metrics of the trade to make comparison.
We bought at the breakout at the close of that breakout candle, the buy price was therefore 88 dollars.
Our exit price would have been in the region of 405 dollars, providing an absolute return of 360%, however, the important comparative metric is the return on risk, we need to know the risk at stake to obtain that return. We already established that our maximum risk was 10% based on the stop loss order, we can therefore calculate our return on risk as 1 to 36, therefore we risked 1 dollar to return 36 dollars, a huge difference to the previous examples.
But the story does not end there, lets pull this data together and show how each approach, combined with leverage, changes the dynamic even further.
On one end of the scale, we have the dumb money, or general public, they bought late in the cycle in the height of enthusiasm, got greedy and held on in denial until price capitulated, this resulted in a loss of 66% of their money, and to get this return they put 100% of their capital at risk by not applying risk management in the form of a stop loss. Their risk reward therefore equated to 1 to 0.66.
We assume a $5000 dollar investment, and because 100% of this is at risk due to zero risk management, I also assume, and advise for that matter, that no leverage is applied. Leverage on any singular stock trade without a stop loss or a strict form of risk management is a definite no no. The outcome for this trader was a loss of $3300 and had they used a 2 to 1 leverage factor, this would have doubled the loss to $6600, more than their deposit.
Next we have the smart money, this group managed to buy on confirmation of price rising out of its base, way before prices got artificially inflated through dumb money.
They exited somewhere close to the top at the first sign of buying exhaustion. This resulted in a return of 430%, but remember this group also did not use a stop loss order and therefore assumed a risk of 100%, which equated to a return on risk ratio of 1 to 4.3, risking $1 to make just over $4. They also invested $5000, used zero leverage and managed to achieve a profit of $16,500.
Next we have my approach which had a 360% return, although instead of risking 100% like the investors above, we used a stop loss, limiting our risk to 10% and providing a risk on return ratio of 1 to 36. Now this is where the impact of leverage becomes a key factor. We deposited the same $5000 as the other traders, but only 10% of this amount was at risk, equating to $500, with this $500 dollar risk in mind we can comfortably apply a leverage factor of 2:1, meaning we are now multiplying the risk of $500 by 2, but equally multiplying the position size and total return by 2.
The profit on this trade now becomes $26,000.
Can you see how applying a stop loss not only allows you to limit losses, but allows you to apply leverage, in this example the first group of investors had all their $5000 dollar investment at risk, yet in my approach we only risked $1000 of the $5000 invested and had a far superior return.
So what can you take from the video?
Be aware of the phases within a stock chart, try not to get caught up in over enthusiasm and have an exit plan for when things turn sour. Establish a buying point which allows for a reasonable stop loss and solid risk management, and apply the power of leverage to get efficient use of your capital whilst enhancing returns.
There are so many behavioural factors to consider in the stock market, the key is to ignore them, devise a set of objective rules, apply optimum money management and grow your wealth without emotion.
Thanks for watching, if you enjoyed the content please hit the like button and if you think it could benefit someone else, why not share it.
Bye for now.
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