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How to Spot an Overvalued Stock

Time:2020-05-13 10:25Shoes websites Click:

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When market volatility sets in, the savvy investor looks for opportunities. If stocks are overvalued, employing a shorting strategy could help you reap gains in your portfolio, but it’s not without its risk. Short-selling involves borrowing stocks, selling them at their current price, then repurchasing them later at a lower price so you can return them to the investment firm you borrowed from. If the price drops, you see a profit. This tactic can be profitable if you’re able to identify the right stocks at the right time. Knowing how to recognize an overvalued stock is essential if you’re considering a shorting strategy to capitalize on market trends.

Overvalued Stock, Definition

First, it’s important to understand what it means for a stock to be overvalued. Generally, a stock is considered to be overvalued when its price isn’t justified by its earnings outlook. In other words, the stock trades at a price that’s above its fair market or intrinsic value. So if a stock’s intrinsic value is $10 per share but it trades at $20 per share, it would fit the definition of being overvalued.

There are different reasons why a stock may become overvalued. For example, the stock’s price may hold steady or increase even as the company’s underlying fundamentals taper off. When investor confidence is on the rise, pushing up demand for a particular company’s products or services, that can also result in an overvalued stock. And a stock could also be considered overvalued if prices continue to rise, despite earnings falling short of predicted growth estimates.

An overvalued stock is the opposite of an undervalued stock. When a stock is undervalued, it trades at a share price that’s below what the stock is actually worth. This type of stock is typically most appealing to value investors who rely on a buy-and-hold strategy.

Shorting Overvalued Stock in a Volatile Market

The premise behind shorting a stock is that you can capitalize on downward trends. So if you come across a stock that’s overvalued and short it, you could theoretically make money once the price begins to drop.

Short-selling can be risky because you’re essentially betting that an overvalued stock will eventually drop in price. You borrow the shares, then sell them to a buyer who’s willing to pay the current market price. And if the stock’s price declines after you sell, you buy it back at the new lower price and return the shares to the lender. Where you make money is in the gap between the buy price and the sell price.

The main risk with shorting overvalued stock during periods of market volatility is the potential for a trend to reverse. You may invest in a stock that you think is certain to drop in price, but if that doesn’t happen and the stock’s price actually begins to rise instead, you could lose money.

That’s why knowing how to identify overvalued stocks is so important. Since this type of investing strategy is speculative, it’s important to minimize room for error as much as possible. That means being able to lock in on overvalued stocks that are in a downward trend and are likely to continue following that trend for the near-term at least.

How to Spot an Overvalued Stock

Man using a binocular

If you’re on the hunt for stocks that are overvalued, studying certain ratios can help point you in the right direction. These ratios can be the most useful when gauging whether a stock is overvalued or undervalued.

Other factors and trends can help you spot an overvalued stock as well. For example, look at the current demand for the stock and what’s driving it. If there’s a sudden surge in buying activity, the result could be a rising per-share price that may not have happened otherwise. That could lead to stock prices becoming inflated.

On the flip side, look at selling activity. If high-profile investors are selling their shares in the company, that may indicate that the stock is overvalued. The same goes for insider trading, which the SEC keeps public track of. On the other hand, if investors are sitting tight that could mean they’re more confident in the stock’s value and its potential for continued price appreciation.

Going back to a company’s fundamentals can give you insight into what’s driving value and whether the stock is priced fairly in relation to earnings and demand. Earnings reports can be useful when analyzing short-term trends and forecasting a company’s potential for long-term growth.

Finally, pay close attention to what’s happening in the market in general. During periods of market volatility, for instance, stocks can flip flop between bearish and bullish in a single day. If something significant is happening to shake up the U.S. economy or the global markets as a whole, that can complicate how easy it is to identify overvalued stocks for a shorting strategy.

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