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What is the 50% rule in trading?

investopedia.com - Fifty Percent Principle Definition - Investopedia

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What Is the Fifty Percent Principle?

The fifty percent principle is a rule of thumb that anticipates the size of a technical correction. The fifty percent principle states that when a stock or other asset begins to fall after a period of rapid gains, it will lose at least 50% of its most recent gains before the price begins advancing again. Key Takeaways The fifty percent principle is used to predict how much value a stock will lose during a correction. It states that if an asset drops after a price increase, it will lose between 50% and 67% of recent price gains before rebounding. Technical analysts use the fifty percent principle to identify a good entry point into a particular stock and ensure that there support levels to prevent further drops. The principle works because most investors share the same behaviors when faced with a price drop. The fifty percent principle works best for short-term trading and may be less effective in the case of major economic events.

Understanding the Fifty Percent Principle

The fifty percent principle predicts that when a stock or other security undergoes a price correction, the price will lose between 50% and 67% of its recent price gains before rebounding. As a tool of technical analysis, traders use the principle to predict the ideal entry point in order to maximize profits when the upward trend resumes. The fifty percent principle is one of several technical theories that attempt to identify support levels in market behavior. Understanding this principle guides other charting techniques, such as pattern analysis and Fibonacci ratios, when following a stock price bouncing between its support level and new highs. This form of chart analysis is most often used in short-term investing. This is because it’s risky to rely on charting for longer periods due to the unexpected impacts of major economic events. Large events, such as the financial crisis of 2008, reconfigure the total economy and markets. An investor who adheres to the fifty percent principle and starts buying after the expected correction occurs may lose money if the price continues downward due to larger events such as a shift from a bull market to a bear market. Like other forms of chart analysis, the fifty percent principle is generally used for short-term investing. It is less effective for longer periods, due to the potential impacts of major, market-changing events.

Fifty Percent Principle Example

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As an illustration of the fifty percent principle, imagine a hypothetical Company ABC whose price rises from $100 to $150, before falling back to $140. The trend line looks fairly consistent in its upward trajectory, and an incautious investor would be tempted to buy ABC for $140. However, according to the fifty percent principle, ABC still has room to fall before any likelihood of a rebound. Since the price of ABC rose by $50 before the correction started, the fifty percent principle states that it will fall by $25 to $33 from the peak, before potentially rising again. A trader who follows the principle would therefore set buy orders at a price somewhere between $125 and $117.

Special Considerations

Much of investor behavior is driven by market psychology. The more investors believe in the fifty percent principle, the more it will continue to drive price momentum. This becomes a self-fulfilling prophecy, since most investors try to profit by following the market. A fascinating exception to herd mentality psychology can be seen among contrarian investors, who intentionally stray from the herd to bet against the wisdom of the crowd. In some cases, particularly during periods of irrational exuberance, it may be more profitable to resist the herd instinct. What Is the OFAC Fifty Percent Rule? The fifty percent rule is used to identify entities that are sanctioned by the Office of Foreign Assets Control. It states that if blocked persons collectively own more than 50% of a company, trust or other entity, that entity is itself blocked by OFAC and cannot receive transactions from any U.S. entity. Although there are some suggestions, this rule effectively prevents sanctioned individuals from using the global banking system. What Is the 50/20/30 Rule? The 50/20/30 rule is a rule of thumb used in household budgeting. Originally popularized by Elizabeth Warren, it says that 50% of a family's after-tax income should be spent on "needs," such as groceries, insurance, bills, and rent or mortgage payments. Of the remainder, 20% should be spent on savings, while the remaining 30% can be used for unnecessary "wants."

investopedia.com - Fifty Percent Principle Definition - Investopedia