What does it mean when a stock has gone “parabolic”?

Financial reporters use the term “parabolic” to describe the behavior of a stock, and occasionally the market in general, whose value has increased dramatically in a short period of time. As a general rule, investors should view such reports as warnings.

News about a company can often drive its share price rapidly higher as new investors and day traders jump on the bandwagon. After the initial burst of enthusiasm, the price may go down for a few days before it starts to rise steadily again. Patient investors who invest for the long term tend to first research the company before buying to see if recent developments improve their company’s fundamentals.

This is not the case with a parabolic situation. What happens is that the stock price just continues to rise relentlessly as more and more investors create what seems like an endless cycle of higher prices each trading day. The daily chart will take on the characteristic of an exponential curve appearing vertical in its pattern.

Every trading day, more investors buy shares of the company. This increase in demand tends to create strong upward gaps in price. The process can continue for several weeks as the share price first doubles, then triples, and so on, until the valuation far exceeds the usual parameters investors use to evaluate a company’s stock.

But no one seems concerned as the share price continues to rise. Confidence of hysterical proportions develops in the minds of investors, who seem convinced that the share price will simply continue to rise without end.

These situations invariably end with the same result. One day, usually during the middle of the session, the price reaches a peak and then starts to decline. At first, it seems that some day traders are making quick profits of a few points. Because confidence is so high, investors are expecting the meteoric rise to resume. But the price keeps going down.

At this point, panic buying reverses to become panic selling. The price then starts to drop sharply for the rest of the session, opens lower the next day, and continues its decline almost as fast as it rose. Early buyers can still walk away with a nice profit, but latecomers who simply viewed a small dip as a temporary setback often end up selling their shares at a huge loss.

The parabolic situation can be compared to the growth of bacteria in a culture dish. These organisms divide repeatedly as the total population increases exponentially. A single organism becomes two. These two divide to become four. Those four divide to become eight. The total population on the plate expands rapidly until thousands, perhaps millions, of single-celled organisms grow and divide.

The nutrient that the bacteria in the dish were feeding on is then depleted. In the case of a stock whose price has been increasing exponentially, it is about not showing up more buyers willing to pay even higher prices. The result on the cultural plate is a massive die-off and a collapse in stock prices.

Anytime an investor hears or reads the word “parabolic” attributed to a stock, they should consider it a caveat emptor, or “buyer beware” situation. If he decides to take a stock position, he must first understand that there is a high degree of risk associated with such a decision. If the investor is not in a position to watch the stock price consistently, the best course of action is to avoid it altogether.