You Can Profit From Flash Crashes

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 (NYSE: PG  ) and 3M (NYSE: MMM  ) , whose shares saw ridiculous discounts during the event.

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:

Stock

% Drop At Friday's Low

Overall % Change at Friday Close

American Capital Agency (Nasdaq: AGNC  ) (22.2%) (1.4%)
Annaly Capital (NYSE: NLY  ) (18.6%) (2.8%)
Invesco Mortgage Capital (NYSE: IVR  ) (16.5%) (0.8%)
Chimera Investment (NYSE: CIM  ) (16.3%) (1.6%)
Hatteras Financial (NYSE: HTS  ) (14%) (3.1%)

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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Fool contributor Dan Caplinger envies those who are fast enough on the trigger to grab flash-crash specials. You can follow him on Twitter here. He owns shares of Chimera Investment. The Motley Fool owns shares of Chimera Investment and Annaly Capital Management. Motley Fool newsletter services have recommended buying shares of 3M and Procter & Gamble. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy is there in a flash for you.


Read/Post Comments (3) | Recommend This Article (14)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 02, 2011, at 2:11 PM, worthless111 wrote:

    Dan, I wish I had read this before last month. I thought the stop order loss would be indexed by funds whom knew 10 % triggers 11 % and would calculate the bottom they put in the buy cycle. Sorry I had to learn the 10 % lesson ( bad for self esteem ) but hopefully I will not be fooled again. Itmakes me mad that Obama stopped the bank fall but nothing is done about the corrupt dumping in the mortgage business !

  • Report this Comment On August 02, 2011, at 2:46 PM, milfalcon wrote:

    OK, so what *SHOULD* I do instead of stop-loss orders to protect myself? I did get burned (on NLY) last week due to a stop loss. I can't thoroughly investigate all my stocks every day to decide whether to buy or sell, so I put in stop-loss orders at some point (usually about 25%) below the buy price, then update things every few weeks when I review what I own. The thinking being that I won't lose my pants just because I don't religiously follow the market and miss an event that fundamentally alters a stock's value. This seems to make sense, except in the case of a flash crash.

    So without checking on every stock every day to see if the fundamentals have changed how can you protect yourself against fundamental value losses AND flash-crashes?

    I'll supply an example where my policy helped me: I owned Transocean before the gulf disaster last year. The stop loss kicked in before I was even aware of the disaster (I'm on the West Coast, which doesn't help in reacting to emergencies since the market has been going for a while before I even wake up, not to mention the fact that I have a job that usually disconnects me from the outside world most of the day). That's an extreme example (obviously I was aware of that disaster and capable of making sell decisions pretty rapidly in that case). But earnings misses, bad news from the FDA, product recalls...all these things could happen and hurt a stock and I won't necessarily notice for a while since I don't want to look at stock news every day.

    What this article tells me is I basically shouldn't invest in individual stocks unless I can monitor them like a hawk to take advantage of other "less sophisticated investors", which isn't very helpful.

  • Report this Comment On August 02, 2011, at 7:11 PM, worthless111 wrote:

    Milfalcon, as mad as I have gotten in the past, he is right when he states " until everyone realizes that traders can take advantage of this predictable behavior ". I was thinking it was illegal to run the stocks down and have your buddy run them up ( CIM down and back in 1 hour ) but it is not. Eventually, even as dumb as I am , I will figure the con game out and go to cash the second I feel it coming !

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