When you see a stock heading towards a 52-week high, what is your initial reaction? Do you think that the stock is hitting powerful resistance and you should sell? Or is the stock about to rally with high momentum?
This is a difficult and highly debated issue with many theories and analysis supporting different views.
A 52-week high is simply the highest price at which shares have traded over the past year. Numerically, this reference point holds no special value, but on a psychological level, it has a profound impact on investors and can greatly influence the share price.
So how do prices react around the time a stock is trading near its annual high?
Effect of 52-Week High on Stocks
Psychology of the 52-Week High
To understand the 52-week high, we must first discuss the importance of price levels and support. Consider the following two examples:
- If a stock falls down to $10 per share and then bounces back up, $10 becomes a psychological support level. Next time shares drop near that level, some investors will confidently buy, and thereby drive the price up. A price support is created at $10 a share for this stock.
- If a stock trades up to $20 and then falls below it, the $20 price level becomes a psychological barrier. The next time a stock makes a run at that level, some investors will apprehensively sell their shares in fear of another reversal. For this stock, $20 has become a price resistance.
The 52-week high has a similar effect. The 52-week high becomes a resistance and the 52-week low becomes a support.
Share Prices and the 52-Week High
How do share prices react when heading toward a 52-week high?
Share prices are obviously rising as the stock heads toward its annual highs. However, some investors become nervous that the 52-week high represents a high-risk price level since share prices have not exceeded this level in a year, and sometimes longer. This psychological barrier or resistance prevents many investors from opening positions or adding to existing positions, while encouraging others to sell some or all of their existing shares.
It is an interesting dynamic since a rise in the stock price probably reflects good news. Perhaps sales are up, profit is increasing, or the future earnings prospects are bullish. Yet, despite this news, the powerful mental barrier of the 52-week high keeps prices compressed – at least for a while.
But generally, if the news is good and the fundamentals are strong, these factors eventually prevail and the stock breaks past the 52-week high. Once it breaks through, share volume will vastly increase and the coiled stock typically makes a jump in excess of average market gains.
One theory behind this jump is that most stock investment research websites have 52-week high lists. These lists drastically increase visibility of the company to potential investors once their 52-week high is surpassed. Stockcharts.com, Nasdaq.com, and The Wall Street Journal are three that widely publicize these lists.
Stocks trading past their 52-week highs outperform the market on average. But how long does this effect last and in which groups of stocks is the effect most pronounced?
Analyzing the 52-Week High Effect
In their paper, “Volume and Price Patterns Around a Stock’s 52-Week Highs and Lows: Theory and Evidence” (2008), Huddart, Lang, and Yetman researched both small and large cap stocks to determine whether there was a correlation between market capitalization and excess returns upon crossing 52-week highs. Below is the summary of the average excess gains over the market immediately following the event:
- Small stocks crossing their 52-week highs produce 0.6275% excess gains in the following week
- Large stocks crossing their 52-week highs produce 0.1795% excess gains in the following week
- Small stocks crossing their 52-week highs produce 1.8963% excess gains in the following month
- Large stocks crossing their 52-week highs produce 0.7035% excess gains in the following month
The excess gains of stocks crossing their annual highs decreases with time. Small stocks initially produce the largest gains, while gains in the weeks following the event decrease significantly. Larger stocks also experience greater gains during the initial week, though not to the same extent as small stocks do. Generally, excess gains from small stocks far outpace those from larger stocks over the first week and month following the event.
The empirical data suggests that an exploitable trading strategy would be to buy small capitalization stocks as they cross above their annual highs. Are there any other effects and uses for the 52-week high other than short-term excess gain?
Other Effects & Findings Associated with 52-Week Highs
- In their paper, “Industry Information and the 52-Week High Effect” (March 2011), Hong, Jordan, and Liu show that the 52-week high effect of individual stocks is highly correlated to the entire industry group. When an entire industry group nears its 52-week high, the excess gains of stocks within this group also hitting their annual highs are greater. This correlation can be used to enhance the reliability of the 52-week high strategy. That is, if both an individual stock and its larger industry group are nearing 52-week highs, investors should seriously consider buying the company’s stock. Fortunately for investors, many websites will track the movement for entire industry groups, allowing them to spot which ones are nearing 52-week highs.
- Other research indicates that the 52-week high is the most common merger and acquisition buyout threshold price. When offers come in above this value, the acceptance rate goes up. This is borne out in the paper, “A Reference Point Theory of Mergers and Acquisitions” (2009), by Baker, Pan, and Wurgler.
- Heath, Huddart, and Lang discovered a distinct link between employees exercising their company options and the 52-week high. They followed 50,000 employees and discovered that the prevalence of the exercise of employee stock options doubled when 52-week highs were exceeded in company stock. This research can be found in their paper, “Psychological Factors and Stock Option Exercise” (1998).
These studies illustrate that the behavioral aspect of the 52-week high is evident in broader industry groups and influences the decision-making process of accepting buy0ut offers or cashing in stock options.
Cause of 52-Week High Excess Gains
Some claim that the excess gains are a result of increased risk. That is, the anomaly of higher excess gains while stocks are trading near their 52-week highs is simply a reflection of the higher risk that accompanies these stocks. The added profits are therefore similar to compensating investors for taking on extra risk.
To account for this, researchers controlled for various risk factors, such as momentum and market movement, and discovered that excess gains persisted. To put it another way, after accounting for the risk-related reward, there was still money left on the table. Thus, some of the excess gains could not be explained by higher risk.
It seems excess gains come from investor under-reaction to positive news when a stock is nearing the 52-week high. While the stock should be trading at a certain level based on available information, the fear of the stock nearing 52-week high resistance weighs down share prices. Once the 52-week high resistance is finally breached, the stock pops upwards to its “correct” pricing. This action in price movement goes against the efficient market hypothesis, which argues that prices trade at their inherent value at all times.
Whether you prefer to trade based on the 52-week high effect or not, the anomaly is real. The excess gains from this effect are most pronounced over very short periods of time, and the largest profits are made on thinly traded stocks with little coverage (i.e. small and micro-cap stocks).
Regardless of whether you choose to trade this phenomenon or not, the 52-week high has transformed itself into an important anchoring point in the minds of many investors, and has significant effects over share prices.