At first, there’s smart money.
Behind this white-collared term are pioneering investors who believe in thorough research, and who are willing to take risks.
Smart money goes into an underlying, and the price of this underlying moves up. Wave 1.
At the sidelines, there are those who have been stuck in this underlying. As the price moves above their entry level, they begin to off-load. There’s a small correction. Wave 2.
By now, news of the smart money has perforated through the markets. Where is it moving? What did it pick up? Who is behind it? Thus, more investors following news or fundamentals (or both) enter. The price moves past the very recent short-term high of Wave 1, accompanied by a surge in volume.
This is picked up on the charts by those following technicals, who enter too. By now, there are analysts speaking in the media about the turn-around in company so and so, and a large chunk of people following the media do the honours by entering. Wave 3 is under way.
Technical trend-followers latch on, and soon, we are at the meat of Wave 3, i.e. the middle off the trend.
Analysts on the media then speak about buying on dips. All dips are cut short by a surge of entrants seeking to be part of the crowd.
The first feelings of missing the bus register. The pangs of these cause more people to enter.
Meanwhile, the short community has been getting active. Large short positions have been in place for a while, and they are bleeding. Eventually, the short community throws in the towel, and there’s massive short-covering, causing a further surge in price.
Short-covering is sensed by gauging buying pressure despite very high price levels. It is the ideal time for smart money to exit. That’s exactly what it does, without any dip in the price of the underlying whatsoever.
Short-covering is over. Smart money starts boasting about its returns of X% in Y days, openly, at parties, in the media, everywhere. This causes pangs of jealousy and intense feelings of missing the bus in those still left out. Some enter, throwing caution to the wind.
The price has reached a level at which no one has the guts to enter. Demand dries up. With no buying pressure, the price dips automatically. Bargain hunters emerge, and so do shorters. The shorters sell to the bargain hunters right through a sizable dip. This dip happens so fast, that most of the crowd still remains trapped. Wave 3 has ended, and we are now looking at the correcting Wave 4 in progress.
At this stage, technical analysts start advising reentry upon Fibonacci correction levels. Position traders buying upon dips with margin of safety enter, and so does the second-last chunk of those feeling they’d missed the bus. The price edges up to the peak of Wave 3 and past it. That’s the trigger for technical traders to enter.
We now see a mini-repeat of Wave 3. This is called Wave 5. Once Wave 5 crosses its meat, the last chunk of those still feeling they’d missed the bus makes a grand entry with a sharp spike in the price. These are your Uncle Georges, Aunt Marthas and Mr. Cools who know nothing about the underlying. They cannot discern a price to earnings ratio from an orangutan. They desperately want to be a part of the action, since everyone is, at whatever the price. And these are the very people that traders sell to as they exit. With that, the crowd is at its peak, and so is the price. There are no more buyers.
What’s now required is a pin-prick to burst the bubble. It can be bad news in the media, the emergence of a scandal, a negative earnings report, anything.
The rest, they say, is History.