I call a stock frothy if it’s up 50% or more over the past year or so. When a stock doubles, triples, or like Tesla is up 800% over a short time period, there is a good chance the price will fall.
So how do you safely buy a frothy stock?
When a stock is up that much, the "fundamentals" of the company, its ability to make money, won't protect you from a bunch of investors just deciding to cash in on their 2-8x gains. This pushes the stock price lower, often "returning to mean", or the natural trend it was on.
So you're like hey, I want some Tesla stock, but I don't want to get caught buying at the peak and losing out. Here's what I do.
I buy the stock in smaller chunks.
This is called "averaging down".
Averaging Down is similar to Dollar Cost Averaging, but instead of averaging over time, you are specifically trying to average over price.
Averaging down can be tough, it's like "throwing good money after bad". But not if you plan for it up front by breaking your investment into smaller chunks.
So if you have $100k you want to invest in Tesla, don't buy $100k all at once. Break it up into $25k purchases.
Buy $25k now to “start a position” and then plan to buy your other chunks at lower prices.
Which prices? Ask a chartist! Good prices would be those at "lines" of resistance or on the 200 day or 50 day moving averages. Generally look for prices where previous trading hung around at.
Looking at a chart of Tesla now, I'd pick $700, $550, $420, and $200 per share. I'm just drawing imaginary horizontal lines of resistance where the price hung out, noticing the 50DMA around the meme price of $420, and the resistance around $200.
You can also just choose prices every 10-25% lower or use indicators like price to sales or price to earnings (PE) as different levels to buy in at.
Couple further questions…
What happens if the price goes up and never goes down?
This is the risk of this strategy and a little sad because you lost out on some upside. However, it's usually okay. By definition something you bought is going up in price.
What happens if the price goes lower after I've invested all of my "chunks"?
This is where I usually say "find more money and back up the truck".
Maybe Tesla isn't worth $200 a share or goes lower, but if you think Tesla is okay to buy at $850, it's GREAT at $200.
Do I every sell?
And if at any time, you lose faith in the underlying company, or you need the money you have invested, you have to sell and take the loss.
If you think Tesla isn't the future of electric vehicles and solar energy, then you need to give up on the investment.
But make sure you are really giving up on the company for your own reasons and not just giving into the pressure of the negative media.
If Tesla stock drops 75% to $200 a share, by definition there is going to be negative press. You need to be able to hold on and keep faith.
This strategy applies to Tesla at this level, GameStop above 1x sales, Bitcoin at this level, or really any asset that has appreciated a lot over the short term or otherwise doesn't have a favorable "margin of safety" when you want to buy in.
Good luck, everyone.