Recent Panic Selling Could Be Caused by Computer-generated Plunge

Traders, exchanges, and regulators try to define what prompted Dow Jones Industrial Average near 1,000-point drop on May 6, 2010. One of the theories is that it was a mistake triggered when a trader accidentally sold billions of shares instead of millions. However, it may be not a case this time.

Firstly this correction was supposed to happen as it was predicted by many. Our cycle analysis calculation even predicted the exact date - May 6, 2010 (see our blog post "Contributing Factors in Forecasting: Stocks vs. Stock Market and Sectors"). Secondly it coincides with a bad news from Greece. The last question is why it was so sharp. Could it be a some kind of high-frequency trading effect? Maybe.

A more simple explanation is the following. Buy or sell order executes very fast if meets certain conditions. This is a modern technologies world. There is a very popular loss-protective strategy in stock investing nowadays – to use a stop-loss order if price drops below 8-10%. Now, let's imagine that more and more orders start executing if prices go down and down. It drags major market indexes down. And this is when traders and investors start to panic and post more selling orders. The prices go down reaching 8-10% threshold faster and faster. It becomes like a loop and results an avalanche.

In conclusion, the question is if stock market regulators will be able to prevent such computer-generated plunges. Probably not. Computers, software, the Internet become faster every year. On the other hand, any artificial restrictions can cause stock market liquidity to suffer. Since the liquidity is a very basic thing for free market to function normally, there is no way to avoid such stock market volatility in the future.

© Alex Shmatov. Published with permission of the copyright owner. Further reproduction strictly prohibited without permission.

Return on Investment Built on Expectations: Time Factor Is Critical in Stock Investing

Since all stock market buy-sell rush built on expectations, today's prices strongly depend on prices that even expected to be in several months. For example, if you are the first who know that today's $20 share would cost $30 in six months, you would rather to buy immediately. What can happen if others have the same prediction? They can do the same - buy immediately and that buying power can push prices higher very fast. Therefore, the price can jump in a few days due to a perspective of several months.

The chart below shows how short-term price behavior can depend on future expectation. Long-term forecast-1 was positive that pushed price up in short-term. Then when new negative information became available, the long term forecast-2 dragged the price down in short-term.




According to Efficient Markets approach, news and other public information are incorporated into the price of a stock with a certain time delay (price is supposed to reach and keep a stable equilibrium that change only each time a relevant new information is known). Since big money cannot flow very fast, individual investors have some advantage to react quickly. To do this efficiently it is important to watch informational resources, monitor companies' news and macroeconomic trends.

© Alex Shmatov. Published with permission of the copyright owner. Further reproduction strictly prohibited without permission.