If you’ve ever traded in stocks or crypto, you’ve more than likely heard the term “bag holder.” Veterans in the market understand the term very well, for reasons we’ll point out in this post. So, if you are just starting out in trading, please take the time to read through this. It may save you a lot of money and a lot of heartache.
What does the term bag holder actually mean?
Being a bag holder is pretty straight forward. It is essentially a term for someone who is left holding the “bags” after someone else has run off with the money.
In the world of stock trading, more often than not, this is the retail investor. Retail investors come to the market with little knowledge of how the market works or how it is designed to take advantage of them — over and over again.
Obviously, the modus operandi of influential and well-funded market participants is to generate demand for their products, i.e. certain stocks. We call them market makers. After all, it is their job to work for companies or institutions who’ve acquired a certain amount of shares and need to make a profit off those shares.
Why bag holders are needed in the market
In order to turn a profit, market makers need someone to sell to. It’s no different than any other marketable product. Buy up all the “widgets” at a wholesale price and store them in a warehouse. Create demand for the widgets, mark up the price, and soon everyone will be wanting your widgets.
As word gets out, like the recent AMC buying frenzy, everyone and their neighbor believes they are going to get rich by buying widgets and selling them when they reach $1000.
After all, that’s the story that all the online promoters and influencers have sold to you right? All it takes is a little fervor in the storyline, and an army full of sheep to believe it, and the market makers have the perfect exit.
Little do they know that there is no other way for market makers to get rid of all those widgets in the warehouse at once. They need a sea of buyers. And as the price rises and rises quickly, they take advantage of the demand to dump all the widgets into unassuming retail buyer’s hands.
Hence, they leave with the money, and you’re left as a the widget bag holder.
Example 1 of a bag holder
Let’s use the AMC example mentioned above in order to gain a perspective of what bag holding looks like on a chart.
Notice on the chart that the stock price more than tripled in a matter of a few days. As the stock continues to rise, it creates a sense of “fomo“. Every one is calling their mother and grandmother and 2nd cousin, Bill, and telling them to buy AMC because it is going to the moon.
The talking heads on CNBC and Reddit and Twitter and everywhere else are all fueling the fire. In essence, the fomo meter is completely maxed out. Get in now, or you’re going to miss out!
So you hesitate, you buy late, and then you HODL (Hang On for Dear Life) hoping you’re going to get rich when AMC goes to the moon.
Unfortunately, as you’re buying, the market makers are cashing in all those pretty little AMC shares that they accumulated at a much lower price. Your FOMO is their exit strategy.
The result, whatever you invested was cut in half as the price dropped 60% from the highs.
How to use bag holding to your advantage
Now that we’ve painted such a grim and menacing picture of bag holding, let’s look at a simple trick. This trick will allow you to use bag holding to your advantage.
The concept of bag holding actually centers around volume weighted average price. We’ve got plenty written on it.
Suffice it to say, a volume weighted average price will tell you at what price “most” of the market participants are “averaged” into the stock. This gives you an indication of the “over/under” for who is holding the bags.
To that point, when a stock is in a sideways trading range, it’s likely that the bag holder hasn’t been determined yet. If a stock is breaking down from a consolidation at the highs, longs are probably holding the bags. And vice, versa.
Let’s look at an example.
Using VWAP Boulevard and Anchored VWAP to find bag holders
There are two indicators we really like when trying to find the bag holders in a stock: vwap boulevard and anchored vwap.
We’ve written extensively on them, so be sure to check out those articles linked above.
Now, let’s look at our AMC example again, but this time with VWAP Boulevard indicators turned on.
Notice in the chart above that there are 5 lines. Most of them are pastel pink and purple. However, the one we have annotated as VWAP BLVD #1 is black. This is the most important vwap boulevard line. It represents the closing vwap of the highest volume day on the chart.
Volume is king in trading. It gives you so much information as to supply and demand and big events in the market.
In this example, notice how the price of AMC fumbled around that vwap boulevard line for many days following the climactic push. This is your over under line. As price begins to break down from that point, it becomes clear that buyers are the bag holder. This is your signal to get out and cut your losses quickly.
Consequently, the price later found some support at a lower vwap boulevard line, VWAP BLVD Line #3, but only after a massive decline in price. So, as you can see, these lines are always worth a look when analyzing price charts.
Using Anchored VWAP to find bag holders
In the same chart below, we’ve now added a red anchored vwap from the highest volume day on the chart. Notice how it acts similarly to the vwap boulevard line we have drawn.
This can be another tool in your belt when trying to find the over/under line for bag holders. Once they start sinking, buyers are now under water.
What happens when someone holds the bags when they are shorting stocks?
Bag holding doesn’t have to be just for buyers. You can have sellers holding the bags as well. In fact, if you are a buyer of stocks, you probably want sellers to be the bag holder. This is the thesis behind all of the short squeezes that have been so popular lately.
Essentially, just like the AMC example above, when short sellers pile into a stock, they expect it to go down. However, if there is enough demand present, the sellers can quickly become overwhelmed as the stock price continues to rise.
Unfortunately, this can lead to catastrophic losses for short sellers, but exponential gains for buyers. Check our recent podcast for an example of how a short squeeze can blow your account.
Let’s look at an example of what this might look like with a quick examination of liquidity traps.
Liquidity traps create short seller bag holders
To trap shorts, you first want to create a high volume day and give shorts the upper hand by the end of the day. Notice HLBZ below has done just that.
Then, you want liquidity to dry up in the ensuing days, while maintaining price at key levels. This creates a predicament for short sellers. How? You might ask?
If you’re going to take a strong short selling position, you need plenty of time and lower prices in order to get out of your position and take profits. If price is kept high enough, and no more selling pressure comes in, this could spell Barney Rubble (trouble) for shorts.
Notice how in the next image, the second day, volume completely dried up:
And then the next day, it was carnage for short sellers. Some news created a catalyst for longs to come in, and shorts bgan to cover as quickly as possible, fueling a squeeze.
You might be asking, but how did you know the over/under line for shorts to become bag holders? This goes back to vwap boulevard again. Let’s look at this example with vwap boulevard drawn on the highest volume day in JFIN.
Note the wick on the first high volume candle. Lots of selling pressure. Then price holds vwap boulevard as volume dries up the next day. Price begins to rise on the third day, and shorts are soon under water.
How to avoid becoming a bag holder
Honestly, it’s a matter of education and discipline. If you don’t understand market dynamics and technical analysis, you’re going to have a hard time making money. Unless, of course, you get lucky. But, luck runs out some times.
The great investor Bill O’Neil taught that you should buy stocks in an uptrend that have paused and then resume their uptrend. This gives you a great opportunity to buy something that is strong. Buying high and selling higher seems counterintuitive, but it’s a lot better than being a bag holder.
Think about it this way, if a stock is showing weakness and beginning to break down, like AMC above, how do you know it will eventually rally? Why not keep your eye on the over/under and save your cash by selling for a small loss. The longer you hold a loser, the more your hard-earned cash depletes.
Follow these guidelines to avoid being a bag holder:
- Never buy into climactic price action
- When retailers are feeling exuberantly bullish, take caution
- Learn the basics of chart patterns
- Never average down on a losing stock
- Cut your losses quickly, and wait for a proper setup
Here at TradingSim, we believe the fastest way to consistent profitability is through trading replay and simulation. By all means, study study study all the gurus you want, but put their strategies to practice in a trading simulator first.
If you don’t want to take our word for it, take it from the worlds most renowned trading psychologist, Dr. Brett Steenbarger.
Here’s to good fills!
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Original source: https://tradingsim.com/blog/bag-holder/