In the financial markets we often hear people talking about bubbles, but what exactly is a bubble and why do so many traders fear these kind of situations?
An overcooked market, where the movement consistently shows an upward direction, and builds up greater distance to what might be considered to be a rational valuation, is called a bubble. But, and that’s an important point, this alone doesn’t mean a downward movement at all, as long the bubble does not burst.
At the moment a lot of market indices are moving strongly upwards, and are close to their all-time highs. Of course, this euphoria tends to be naturally countered by more and more people speaking about a dangerous situation. Some market watchers say that there are bubbles everywhere, and they are highly likely to burst.
The S&P500 (broad US market index) is currently over 2,100 points (what is an all-time high level) but the range of the market also seems to going back down with an average daily movement of around 20 points throughout the past 3 weeks. This is around the mid value within the range of the last year. So is this rally coming to an end right now?
The question should be, do we know what the markets are doing next and where is the peak in a market?
The answer to that is as simple as often – we don’t! What we know is that it is a bubble, and that we should still be able to find lucrative trades in this upward situations. Technical traders shouldn’t care too much if a movement is rational. What we also know is that, if a market turns around and falls like a stone, we are able to find opportunities for attractive downside trading opportunities as well.
So even if the bubble is bursting and the market is losing heavily, we still can stay focused on chances. In fact often times the downward movements travel with a greater level of momentum, which can present quite interesting opportunities for a trader.
So now, is a bubble an opportunity, or a risk?
To be completely truthful, it is both. Inexperienced people might lose heavily when the market is turning, because they could have joined the market too late (which would be quite typical) and most times are not able to participate in both directions. For the Academy of Financial Trading using technical analysis, a bubble is a great opportunity to reach our long-term return objectives. We can use the trend upwards and when the market tells us that it is no longer rising, we exit the trade and maybe use the short direction to profit again.
The most important thing in this situation is to have a good strategy, including a reasonable risk management process.