What Stock Traders Really Fear

Falling stocks have everyone on edge. Yet while you and other long-term investors can ride out the storm, traders who count on short-term strategies have even more reason to be nervous right now.

Most investors buy stocks and other investments for the long run, rather than betting against the market by selling short. So long-term investors are the ones who've borne the brunt of the damage in the stock market over the past year.

Traders, on the other hand, aren't as committed to owning stocks as most investors are. They may sell short one day, then change their strategy to look for gains the next day. Because they often make bets in either direction, traders don't automatically get hurt in a falling market.

Volatility gone wild
What can hurt traders, however, is choppiness in the market. And we've seen painfully high levels of volatility lately -- in both directions.

On Friday, stock futures were locked limit-down before the stock market opened for trading, meaning that futures traders couldn't take positions based on their expectations of how the market would open. Fears of a 1,000-point drop in the Dow, with the consequent trading halts such a drop could have caused, proved overly pessimistic -- but with Dow futures down 550 points with strong downward pressure, the prediction wasn't totally ridiculous.

Not all of the volatility has been on the selling side, either. Last month, stock futures were locked limit-up before one trading session. And although the 900-point gain in the Dow two weeks ago is now just a memory, it also serves as a reminder that when big drops in the market happen, you can also expect to see at least some big rebounds as well.

The real fear
The problem traders have with volatility is that it makes taking any position -- long or short -- more risky. Just look at some of the intraday swings stocks have had during particularly volatile trading sessions:

Stock

% Swing Oct. 13

% Swing Oct. 15

General Electric (NYSE: GE  )

9.7%

8.5%

PotashCorp (NYSE: POT  )

13.4%

23.0%

Sunpower (Nasdaq: SPWRA  )

14.7%

18.5%

Valero Energy (NYSE: VLO  )

25.2%

22.6%

Baidu.com (Nasdaq: BIDU  )

23.3%

11.6%

Coach (NYSE: COH  )

8.7%

16.9%

JPMorgan Chase (NYSE: JPM  )

11.1%

10.0%

Source: Yahoo! Finance.

It's true that such huge intraday moves can magnify potential profits when traders make the right calls on stocks. But it also increases the risk involved in holding any position even for short periods of time, as a trader could easily see a profitable position turned into a loss nearly in the blink of an eye. As a result, when stocks are this volatile, traders with limited capital have to be more careful than ever about the size and timing of their positions.

Why should you care?
So if you're a long-term investor, why should you care about what traders are doing? Isn't their incessant buying and selling just white noise that you can ignore?

It's true that if you have a long-term investing plan where you're making regular, automatic contributions to your savings, trading activity won't necessarily affect you that much. But if you're looking to capitalize on the low stock prices you can find throughout the market, then paying attention to what traders are doing can make your own investments even more profitable.

More importantly, though, traders play a vital role for the markets on a systemic level. As we've seen in the credit crunch, trading activity is the lifeblood of a market. When markets stop functioning, as they have in the frequently closed Russian stock market, the loss of confidence builds on itself and becomes almost irreversible.

It's that potential loss of confidence that has made all of the actions world governments have taken so urgent and vital. And although you can simply wait out the panic, traders don't have that luxury -- and their fear could make the problems plaguing the markets even worse than they already are.

For more on investing in today's markets:

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Fool contributor Dan Caplinger loves watching what traders do. He owns shares of General Electric. JPMorgan Chase is a Motley Fool Income Investor selection. Baidu.com is a Motley Fool Rule Breakers pick. Coach is a Motley Fool Stock Advisor recommendation. Try any of our Foolish newsletter services free for 30 days. The Fool's disclosure policy is never scared.


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  • Report this Comment On October 27, 2008, at 1:24 PM, javnnf wrote:

    But one what the investor should do when a highly recommended stock goes on the downward spiral?

    Look at CBI-- it was recommeded as "on sale", with a 5-star CAPs rating!!

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