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

News about a company can often drive the price of its stock quickly to the upside as new investors and day traders jump on the bandwagon. After the initial burst of enthusiasm, the price can decline for a few days before it begins steadily rising again. Patient investors who invest for the long term tend to research the company first before buying to see if the recent development improves the fundamentals of its enterprise.

This isn’t the case with a parabolic situation. What happens is the stock price simply continues to rise without pause as more and more investors create what appears to be a never-ending cycle of higher prices each trading day. The daily chart will take on the characteristic of an exponential curve that appears vertical in its pattern.

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

But no one seems concerned as the price of the stock continues higher. A confidence of hysterical proportion develops in the minds of investors, who seem convinced the share price will simply keep going up without end.

These situations invariably end up with the same outcome. One day, usually during mid-session, the price reaches a peak, and then begins declining. At first it looks as is some day traders are taking quick profits of a few points. Because confidence is so high, investors expect the meteoric rise to resume. But the price continues to drop.

At this point, panic-buying reverses to become panic-selling. The price then begins dropping dramatically throughout the remainder of the session, opens lower the next day, and continues its descent almost as fast as it rose. The early buyers can still get out with a handsome profit, but those buyers who got in late, and who simply considered a small decline as a temporary setback, often wind up selling their shares at huge losses.

The parabolic situation can be likened to bacteria growing in a culture dish. These organisms divide repeatedly as the total population increases on an exponential basis. A single organism becomes two. These two divide to become four. Those four divide to become eight. The total population in the dish rapidly expands until thousands, perhaps millions, of single-cell organisms are growing and dividing.

Then the nutrient on which the bacteria were feeding in the dish runs out. In the case of a stock whose price has been rising exponentially, it’s a matter of no more buyers showing up willing to pay even higher prices. The result in the culture dish is a massive die-off, and a collapse in the share price of the stock.

Whenever an investor hears or reads the word “parabolic” ascribed to a stock, he should regard it as a situaiton of caveat emptor, or “let the buyer beware.” If he decides to take a share position, it should first be understood there is a high degree of risk associated with such a decision. If the investor isn’t in a position to watch the share price on a constant basis, the best course of action is to avoid it altogether.