Market timing can apply to any security. Stocks are the most common example, but someone can also use market timing to guide their bond, gold, or real estate investments. Anything that’s subject to market forces could be traded with market timing.
How Does Market Timing Work?
Market timing can be employed as an investing strategy in many ways. It all depends on what exactly an investor thinks will happen. For instance, if an investor sees a stock trading at $80 on Monday, and they feel it will drop down to $78 by the end of the week, then they may short the stock or buy a put option that expires Friday. Both of those trades are bearish—they depend on the stock price going down to make money. If the stock price falls as the investor hoped, then they make money. If the stock price rises, then the investor’s market timing fails, and they lose money. The opposite works as well. If an investor thinks a stock price will rise, they may go long on a stock or buy a call option that expires on the day they think the stock will rise by. They may even use margin debt to act on their sentiment, adding extra risk to an already risky strategy in hopes of sudden riches. If an investor sells their stock because they’re afraid about an impending stock market crash, that’s another example of market timing. This particular example shows the high levels of risk and reward that come with market timing. Even if it’s clear that an asset bubble is forming, it’s incredibly rare that someone accurately predicts a crash to the day. However, if someone manages to do so, they’ll be able to buy back into the same positions at a much lower price.
Valuation vs. Market Timing
Valuation involves complex financial analysis that digs into the actual business behind the stock price. Various financial ratios will likely be used to give greater context about how much money the company is making, how it’s making it, and how likely the company is to grow its earnings. To obtain the information needed to calculate these equations, the investor must pore over balance sheets, income statements, and any other financial documents they can get their hands on. Only after assessing the value of a company will a value investor look at the stock price. That’s because the stock price in and of itself matters little to this type of investor. Instead, what matters is how the stock price compares to the overall value of the company. If the stock price is low, relative to the value, then the investor will buy it. If the stock price is much higher than the “true value” of the company, then the investor will look for opportunities elsewhere. Market timing, on the other hand, is solely concerned with a stock’s price. The underlying value of the company doesn’t matter, the only thing that matters is correctly guessing where the stock price will be on a set day. An investor using market timing may study stock charts to attempt to learn the patterns of the stock price, but there’s no fundamental assessment of the company’s actual finances.
