Capitalizing Off of Risk Aversion In The Stock Market

Risk Aversion is a psychological point when a stock is underowned and/or oversold due to fear of another leg down, fear that the stock is still in a downtrend, and a failure to believe the worst is over even after evidence to the contrary. It is the first major failure to break resistance after testing resistance. It typically also represents a "1-2-3 bottom" in which a downtrend has been broken, an equal high has been made, and you buy the following low in anticipation that the low holds and rebounds.

So it's been awhile since I've blogged, but I want to continue to drill into your head the idea off of using emotion to your advantage. If not, you will instead fall pray and be the victim of your own emotion.

Risk Aversion is where the risk is to the upside. Since most everyone has the greatest reason for selling that they're going to get and does so more so out of emotion, it's going to be unlikely for prices to get much lower, and much more likely for prices to go higher. If prices do get lower, there should be support due to the discouragement low buyers that tend to be the "strong-hand", "high conviction" "value buyers" that aren't likely to sell and take a loss so quickly. If prices go higher, there's certainly the possibility for people to jump back on and chase prices higher as conviction and confidence grows.

Here's a recent example of what could be interepretted as aversion which can be seen on multiple time frames at once, ticker YRCW.

Although it can look quite different in terms of the overall action of the chart and duration by which the stock spends it's time at various price levels, the concept is still the same. Downtrend, bottoming pattern, equal or higher high, pull back... and then buy the pull back. Due to different psychological profiles within different timeframes, the time it takes relative to the sentiment chart can change significantly.

In case you don't see what I'm looking at, I want to try to etch out some more details and describe what's going on and why the weekly chart's "aversion" has been drawn out for about 2 years after the initial "aversion" move of about 2 months.

You can see on the daily chart, that it didn't really have as clear of a cycle before reaching enthusiasm. The cycle appears to be pretty condensed and as such some of the signals are a bit more difficult to read.

On the weekly you have the opposite problem. The upside was far overblown and the disbelief and panic were exacerbated to the downside.   Additionally, the "wall of worry" was a bit more enthusastic because it didn't take as much buying to see drastic moves. So the result was that the initial aversion had a nice rally, but didn't take out the wall of worry high. as a result, in some ways the aversion was drawn out and extended into a second leg of discouragement. We also didn't really have clearly defined resistance for the initial test, and instead the wall of worry high was at overbought levels at the time. Considering the hopes for the bulls and fears of the bears would be at larger extremes due to the magnitude of the moves, it's not surprising to have the eyes gravitated to this name until it can work off the hype and become more neglected. Once it is neglected, it is far easier for the stock to rally, take out it's highs and accumulate more attention and get more people chasing, more bears covering, and the stock rocketing higher again.

So in other words, the weekly chart's wall of worry had a lot of people trapped at higher prices either long or short that sold every attempt to rally to new highs, while the "aversion" low created buyers from below and sellers trapped lower that buy every dip. As a result, you see prices contract until one side gives up or overpower the other. If the prices were at less extreme, it wouldn't take as long for this process to play out. Nevertheless, if you sold the "wall of worry" and bought the initial "aversion" you still could have gotten good prices and made good trades.

Disclaimer: I am long YRCW as of the time of this post.