A Guide to Mania Investing and Risk Management Strategies

May 25, 2021 07:58 PM ET
A Guide to Mania Investing and Risk Management Strategies

Mania is a period of euphoria and irrational exuberance in the financial market. It is a period that is characterized by a sharp increase of assets like commodities, stocks, cryptocurrencies, and other financial assets. In this article, we will look at some examples of past manias and how you can make money in these periods.

Examples of past manias

There have been many manias in the past. One of the best-known is the tulip mania that happened hundreds of years ago. It is often said that traders introduced tulips to the Netherlands in the mid-1600s. The flowers were said to be the future, and many people rushed to invest in them. Most families took loans to buy these flowers. Ultimately, their prices collapsed, and many people filed for bankruptcy. 

In early 2,000, the most prominent theme in the market was dot com. At the time, many investors saw the success of several technology companies and decided to invest in them. At the time, any company with a dot.com suffix did well, even those that did not have any revenue or profits. The mania collapsed in early 2,000, in what is known as the dot com bubble.

After the dot com bubble, the financial market focused on the housing sector. At the time, many American banks started to offer mortgages to millions of people. Most of these people had a weak credit score, meaning that it was difficult for them to pay back the money. 

Banks then created products known as collateralized debt obligations (CDOs) that they sold to investors. Ultimately, when most people failed to pay back their mortgages, banks started seeing a significant increase in defaults. The bubble exploded in 2008, leading to the bankruptcies of many people and banks like Lehman Brothers.

How manias form

Manias in the financial market are attributed to what is known as Fear of Missing Out (FOMO). This is a situation where a financial asset’s price or industry starts to do well. As the prices rise, many investors jump in to avoid being left out in the cold. As they add their funds to the industry, their valuations start to get dislocated.

There are many recent examples of this. The most well-known is Bitcoin. In 2020, as the coronavirus pandemic was starting, the price of Bitcoin collapsed to below $5,000. In reaction to the pandemic, the Federal Reserve lowered interest rates to zero and launched a massive quantitative easing program. 

This incentivized people to shift their resources to riskier assets. Within a year, the price of Bitcoin jumped to almost $65,000. Other cryptocurrencies jumped by more than 1,000%, and the total market cap of the currencies reached $2 trillion. Indeed, I know many people who borrowed money to invest in the currencies and saw prices decline sharply. 

How to trade during a mania

Fortunately, it is possible to make money during a mania period and when it starts to wind down. For one, most brokers offer ways for people to buy an asset when its price is rising and short it when it is falling. To trade during a bubble, you need to understand the several phases of euphoria and bubbles.

First, there is displacement, where new technology or paradigm emerges. Some examples of these are the dot com bubble, housing, cryptocurrencies, and cloud computing. At this stage, there are a few people involved and the prices don’t see a parabolic move. 

Second, there is a boom, where the asset’s price starts to rise. This is the stage where many respected investors start to buy and tout their purchases. Third, there is the euphoria phase, where many people start to buy the asset. 

Next, there is the profit-taking place where smart money investors start to exit. This usually leads to a sharp decline of the asset. During the decline, the assets will make several relief rallies. Finally, as the relief rallies fail to hold, a panic emerges, and everyone rushes to sell.

Therefore, if you have a good understanding of this, you will be able to trade during all market bubbles and when they burst.

Risk management strategies

There are several important risk management strategies you can apply when you are trading during a mania. First, look at your financial position before you start trading. This will help you know the amount of money you want to put into your trading account. For example, if you have $100,000 in cash, you can decide to invest about $20,000 of it, provided that you are also making money elsewhere. Ensure that you only trade funds that you are ready to lose.,

Second, always size your investments well. This simply means that you don’t want to risk a lot of money on a single asset. Ideally, you should not risk more than 10% of your account in a single asset. This will help to ensure that your account is safe even when the bubble bursts.

Third, always use leverage well. Leverage refers to a situation where you borrow money to invest. Many people with a good credit score tend to go to a bank and borrow funds and invest in high-flying assets. Others use the leverage provided by brokers to improve their trades. While leverage is a good thing, it can also lead to sizable losses. 

Fourth, always have a trailing stop loss when trading. The stop-loss will automatically stop a loss-making trade at a predetermined level and protect your trading account. 

Fourth, be careful about relief rallies. Always be careful when buying the short rallies that emerge during the distribution phase. In most cases, they tend to end badly.

Finally, always be ready to take profit. If the asset has jumped by more than 100%, it is always important to take profit since this will help you to reduce your risk. You can do this by simply selling your profits and leaving your principal amount still in the trade. 

Summary

A mania, also known as a bubble, is a popular event where the prices of an asset rise so much in a certain period. A bubble can take place in a year or several months. As an investor, this guide will help you make money when a bubble is forming and when it ultimately bursts.


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