Last Updated on 7 April, 2022 by Samuelsson
In the financial trading world, one popular adage about how to make money from the markets is “Buy low and sell high”. While the lesson in that statement is so obvious, it’s not that easy in practice. But what does it mean to buy low and sell high?
Buy low and sell high refers to a trading strategy that corresponds to the up and down swinging pattern of price movements. The trader or investor is expected to buy when the price has gone down (market swing low) and sell when the price has gone up (market swing high).
In this post, we will discuss the following:
- “Buy low and sell high”: what does it mean?
- Understanding “buy low and sell high”
- How to follow a “buy low and sell high” strategy
- The pros and cons of “buy low and sell high”
- “Buy low and sell high” vs. “buy high and sell higher”
“Buy low and sell high”: what does it mean?
Buy low and sell high is a trading strategy where you buy a security when it is lowly priced and sell it when the price has gone up. The strategy is designed to correspond to the up and down swinging pattern of price movements so that you buy when the price makes a swing low and sell when the price makes a swing high.
As you already know, markets can trend upward, downward, or sideways, but they don’t just move in a straight fashion. They move in waves: impulse and correction waves when trending up or down. In the case of sideways movements, they make almost equal upswings and downswings.
With a “buy low and sell high” strategy, you aim to catch the low of a downswing or correction wave during an uptrend so as to buy at a lower, discounted price, hoping the price will continue to move to the upside so that you sell at the high of the next upswing or even at higher swings if you decide to hold on.
On the flip side, if you want to trade during a downtrend, you aim to short at a high price and cover your short at a lower level. So, you try to catch the top of a price rally (correction wave) in order to have a higher profit potential if the market continues to move in a downtrend and then try to catch the lower lows to cover your shorts.
However, this strategy can be difficult to implement as prices reflect emotions and psychology and are difficult to predict — even though we know that the market swings up and down, it is nearly impossible to time the bottoms and highs. The price of a stock at any given time is based on supply and demand, which is fueled by the psychology of the market participants, at that moment in the market. When this dynamics changes, and it frequently does, so does the stock price.
Understanding “buy low and sell high”
The aim of any investment or trading is to make money, which can come in the form of dividend payments or capital appreciation. Here, we are focused on making money via capital appreciation, and for that, there are two major approaches traders use: “Buy low and sell high” and “Buy high and sell higher”.
We are focused on the first one: Buy low and sell high, which means you want to make a profit by buying when the price is low and selling when the price is high. For example, if you can buy a stock at $15 per share and sell it later for $40, making $25 in profit. While this may look easy, it is quite complicated in practice. The strategy relies on trying to time the market — buying low means trying to determine when stocks have hit bottom price and purchasing shares in the hope of them going up while selling high relies on figuring out when the market has hit its peak so you sell your shares and reap the rewards.
While the concept and approach is the same, the manner of implementation is different for investors who use fundamental analysis and traders who make use of technical analysis. Let’s take a look at what the strategy means to these two groups.
What it means to investors
Investors typically make use of fundamental analysis to know the stocks to buy. To them, the idea of buying low and selling high is captured in the investing style known as value investing. This style of investing aims to buy good stocks that are trading below their intrinsic values. In other words, the aim is to buy undervalued stocks. Investors who make use of this approach are known as value investors.
Value investors, such as the Oracle of Omaha, the legendary Warren Buffett, try to calculate the intrinsic value of a stock and then compare it with its current market value to know if it is trading at a discount. A stock is trading at a discount if the current market price is much lower than its intrinsic value. When a stock is trading at a discount, it is said to offer a margin of safety. What this means is that they believe there’s a lower downside risk because it’s already down.
What it means to technical traders
Technical traders analyze stocks using price charts: they try to identify price waves and patterns on the charts and use them to decide when to buy and sell stocks based on the price trend. An uptrend is characterized by the price making higher swing highs during upward price surges and higher swing lows during market corrections (pullbacks). On the other hand, a downtrend is characterized by the market making lower swing lows during down waves and lower swing highs correction rallies.
Thus, for technical traders, “Buy low and sell high” means to buy after a market correction in an uptrend. They call it “buying the dip”. Then, they sell at the peak of future swing highs. When trying to short sell, they sell at the top of correction rallies during a downtrend and try to cover the short at the lows of downswings. Among technical traders, another name for “buy low and sell high” is “buy the dips and sell the rallies.”
How to use the “buy low and sell high” strategy in trading/investing
As we explained above, value investors make use of fundamental analysis to implement this strategy, while technical traders use their chart analysis. Let’s take a look at how they do it:
To value investors, buying low means buying at a discount to the intrinsic value of the stock. But they have to know the intrinsic value of the stock first before they can check whether the stock is currently trading at a discount. There are different methods value investors use to find the intrinsic value of stocks, and these are the most common ones:
- Asset-based valuation
- Analyzing financial metrics
- Discounted cash flow analysis
We will discuss only the first two here.
This is the simplest way to estimate the intrinsic value of a stock. It is more like calculating the book value of the stock. The formula is given below:
Intrinsic value = (Sum of a company’s assets, both tangible and intangible) – (Sum of a company’s liabilities)
For example, let’s say company X’s assets totaled $1 billion, and its liabilities totaled $500 million. Subtracting the liabilities from the assets would give an intrinsic value of $500 million for the stock. If this stock has 50 million outstanding shares, the intrinsic value per share is $10. One problem with this method of calculating the intrinsic value is that it doesn’t incorporate any growth prospects for a company, so it often yields much lower intrinsic values than the other methods.
Assuming the stock is currently trading at $7 per share, you can say that the stock is undervalued as it is trading at a 30% discount from its intrinsic value.
Analyzing financial metrics
For this method, you use financial metrics such as the earnings per share (EPS) and price-to-earnings (P/E) ratio. The formula for this approach is given as follows:
Intrinsic value = EPS x (1 + r) x P/E ratio
Where r = the expected earnings growth rate
For example, let’s assume that Company Y’s EPS for the last fiscal year was $2.00, and the company can grow its earnings by around 10% over the next five years. If the stock currently has a P/E ratio of 20, we can calculate the intrinsic value as follows:
Intrinsic value = $2.00 x (1 + 0.10) x 20 = $44 per share
Let’s assume that the stock is currently trading at $28 per share, then the stock is trading at 64% of its intrinsic value. In other words, it is trading at a 36% discount from its intrinsic value, so it is obviously undervalued. A value investor would be happy to buy at this low price with the hope that the market would later recognize its true value and take it there or even beyond.
For technical traders, it’s all about buying the dip and selling the rally. They achieve this by reading the price chart. The key factor for them is to know how to read the price waves/swings in different trends. There are two price waves in a trending market: bigger impulse waves in the trend direction and smaller correction waves (pullbacks) in the opposite direction.
In an uptrend, there are upward impulse swings and downward correction swings/pullbacks. To buy the low is to buy at the end of a pullback (market correction) before the next impulse wave takes off. But identifying the end of a pullback can be very difficult. Most technical traders use key price levels (support and resistance levels) to gauge where the pullback is likely to end.
They then use certain technical setups to know when the next impulse wave is about to take off. Examples of those technical setups are reversal candlestick patterns, such as the hammer, shooting star, and engulfing patterns. Some traders use oscillators, such as RSI, stochastic, and Williams R%.
The pros and cons of “buy low and sell high”
There are merits and demerits of using the “buy low and sell high” strategy.
These are some of the advantages of this strategy:
It uses the market swinging patterns: The strategy tries to make use of the market swinging patterns, such that you act at the beginning of a new swing. You try to buy at the beginning of a new impulse swing to benefit from that move and sell at the beginning of a corrective swing so that your profit doesn’t get eroded.
It offers some margin of safety: Some investors believe that, for a good stock, since the price is already down, it can only fall much lower, which offers a sort of safety to the downside.
It enables you to buy cheaply: By buying the stocks at a cheap price, you can buy more shares and make more money with any move in your favor.
Some of the limitations of the approach are as follows:
Timing the market is difficult: The strategy is mostly based on your ability to time the market swings so perfectly that you buy around the lows of downswings and sell around the peaks of upswings. Of course, nobody can accurately time the market.
One can miss some great stocks with high momentum: Some of the stocks that make the best money in the market are momentum stocks. These sort of stocks move with great momentum that they don’t often make reasonable pullbacks for those waiting for dips to get onboard. For those sort of stocks, your best bet is to “buy high and sell higher.”
“Buy low and sell high” vs. “buy high and sell higher”
While” buy low and sell high” is about getting undervalued stocks at discount prices, “buy high and sell higher” is about buying into the momentum of momentum stocks. Interestingly, these momentum stocks are often the market leaders, while undervalued stocks are the market laggards.
With the “buy low and sell high” approach, you look to buy the dips, but with the “buy high and sell higher” approach, you look to buy on breakouts when stocks are breaking above old highs and making new highs.
Both strategies make money; just master the one that suits your risk appetite.