We have all heard about the “Rule of 90%” in brokerage parlance and how long a stock should go without trading in. The “Rule of 90%” can be explained as the ratio of the cost of investing at the outset to the earnings potential (the number of stock changes needed to double the earnings potential). A stock should trade at or below 90% if the expected returns on the company are between 4 and 10%. So the rule tells us that when a stock is trading at just under 90% of its earnings, then a 12% swing has been exceeded, which should be considered a signal that the company’s stock is overvalued.
The same ratio is calculated to determine the duration of a swing, which represents the portion time from the initiation of trading to the date the share price reaches the $2.00-referrals (equivalent to the number of times the stock price goes below $2.00 in the trading day) threshold. This is called the “rule of 52%” (the 52-week period) as this is the period that follows two consecutive 52-week periods when the stock price is at least $2.00 (equivalent to the number of times it is below $.50 during a 52-week period, or $2.90 if the 52-week period represents a period of four 52-week periods).
Let us see how this works when we use a hypothetical example.
For our example stock, let’s say that it has a dividend yield of 11%. In this scenario, it would have a 12-week cycle with a 1-week interval during which it trades for under $2.00 (4 times its average volume over the 24-month period. At the end of the 12-week cycle, the price would close at $1.05, implying it should not be trading for $2.05. So if the 12-week cycle length is equal to 3 months, then it would be trading for $1.05 at the 52-week marker on the 12th day.
So in a 12-week swing period, an investor could put in $800 as it would only make its investment of 80% (100%) if it is under $2.05 for all three trades in the cycle! But what would happen if the stock had been trading for 1-2% or a low of around $0.50 for its entire 12-week swing? How long would it take to trade at less than $1
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