Now more than ever, many investors think that the stock market is rigged. Those conspiracy theorists got another piece of ammunition to add to their arsenal last week, when fears of an imminent U.S. Treasury default led some shareholders to dump huge numbers of shares shortly after the market opened on Friday -- only to see the stocks reverse course and regain most of their losses.
For those who see volatility solely as a measure of risk, these big share-price moves look decidedly unattractive. But if you like the idea of getting opportunities to bargain-hunt on your favorite stocks, then even extreme volatility can be your friend.
The flash crash revisited
More than a year ago, the Dow Industrials endured a gut-wrenching drop of nearly 1,000 points in the space of just minutes -- immediately followed by a reversal of nearly the entire move down. The move, later dubbed the Flash Crash, resulted from massive sales of stock index futures contracts, but it had a huge impact not only on the major market indexes, but also on individual stocks like Procter & Gamble
Last week, investors in several companies in a highly specialized sector of the market got a whiff of the same sort of stomach-turning plunges that made so many people angry about the original Flash Crash. Many real estate investment trusts that invest primarily in mortgage securities saw their shares plummet in the first hour of trading, before quickly bouncing back. Here's a list of the damage:
% Drop At Friday's Low
Overall % Change at Friday Close
American Capital Agency
Invesco Mortgage Capital
Source: Yahoo! Finance.
So what happened? Fellow Fool Rich Smith noted later that day that interest rates on repurchase agreements, on which mortgage REITs rely for their financing, moved upward from around 0.1% to 0.2% in light of the ongoing debt ceiling crisis. But the companies themselves downplayed the event, and investors later agreed that the small interest rate rise only merited a small discount on the shares, rather than the double-digit percentage losses they initially inflicted.
The mechanics of a crash
In all likelihood, though, the real culprit had to do with the protective measures that many investors take. By using a stop-loss order, you can tell your broker to sell your shares if the price goes below a certain level. The theory behind using stop-losses is that you pick whatever maximum loss you're willing to take on a stock, set the stop loss level there, and thereby ensure that you'll get at least that amount back out.
But the stop-loss strategy has a couple of problems. First, when share prices are moving erratically, you can't be sure that you'll be able to sell your shares for anything close to your stop-loss limit price. That leaves you with two equally unpalatable alternatives: Sell at a much lower price than you expected, or hold on and admit that your strategy didn't work.
From a broader perspective, though, stop-loss orders can make big stock price movements even worse. As a falling stock triggers stop-loss orders, the resulting selling pressure can push the shares even lower. That further fall can then trigger new stop-loss orders at lower price points, creating an avalanche of selling that only stops once the orders have all triggered. Then, in the sudden vacuum of selling, buyers often push share prices back up quickly. The result is a small loss for the day for the stock, but those who sought to protect themselves find that they've sold out at those temporarily low levels.
It's up to you
Taking advantage of stop-loss orders to create mini-flash crashes isn't the only way that opportunistic traders can profit from less sophisticated investors, but it's a particularly nasty one, because it uses your own risk management strategy against you. Until everyone realizes that traders can take advantage of predictable behavior, these events will continue to occur -- and you'll do better trying to go against the selling frenzy rather than becoming another victim of it.
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