Panic Selling by Online Traders Causes Market Volatility

They were conditioned to expect markets to bounce back, and when that didn't happen, they unloaded.
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Maybe you're reading this column to see if the momentum traders have a different perspective on the action of the last few weeks. Traditional analysts have come up with hundreds of clever ways of saying they have no idea what happened.

Most investors on the street aren't comforted by this lack of explanation and are still in a state of shock. They can't believe that the stocks in their portfolios, strong ones with great earnings and fundamentals, took a nose dive with the rest of the market. So what happened? I certainly don't have all the answers, but here's my momentum-trader perspective on how we got here:

Prior to the Internet rage, we, the professional daytraders, were playing mostly smaller stocks, anything that was moving and showing volatility. At the time, these smaller stocks were the only ones with the momentum that interested us. The larger stocks over $40 simply were not moving as much.

I started noticing the larger Internet stocks showing increased momentum, and more volatile swings. Reporters called me and asked if daytraders were causing all the volatility in the Internet stocks. I said no, but it certainly wasn't the institutional guys. They were not touching stocks with such ridiculous prices compared with next year's earnings, which in many cases were non-existent.

I didn't realize who was causing the Internet stocks to roller-coaster until I began watching and playing them myself. Many rose to incredible heights and made swings well over 20% in one day, attracting the attention of professional momentum traders and brand new market players. The big elephant who jumped into our trading pool was the online investor. He took his retirement funds out of the hands of the pros and went on buying sprees, purchasing Internet, China, business-to-business, biotech and other tech-oriented companies such as those producing fuel cells. Anything with a sexy story.

In the beginning, I think online investors intended to hold these stocks as if they were buying

Microsoft

(MSFT) - Get Report

in its infancy. But the resulting momentum, driven by both online investors and daytraders, created fast and furious climbs that turned many from true investors into

momentum traders

.

Phenomenal gains were made in a very short period of time in stocks such as

Qualcomm

(QCOM) - Get Report

. In my opinion, this is one reason why we are seeing such lows and extreme volatility lately. Anyone who has daytraded momentum and has been on the wrong side of a trade will understand the reason behind the momentum we see now. For those of you who have not traded momentum, let me try to explain.

Take a look at the dips in the

Nasdaq

chart. Every time the market dipped, online investors bought, and those who were already in, held. Each dip had the same effect on the psychology of investors as a daytrader who does not keep a stop-loss. The first time a daytrader misses a predetermined stop as a stock heads south, it scares the pants off him. The worst thing that can happen to an undisciplined trader, believe it or not, is to have the stock dip, bounce and then make a new high creating a huge profit for the trader. It creates a sense of complacency and reinforces poor trading habits. The next time a stock starts to dip, the trader is more apt to ride out the next dip and the next. After all, the last time it recovered and made phenomenal gains; why not this next one?

The series of dips, recoveries and new highs we have been seeing since October 1999 has "conditioned" online investors in much the same way. They either bought more or held through the dips. After all, they tell themselves, "it always bounced and made new highs before." See the similarity?

Institutions joined the party, trying to compete with these phenomenal gains being made in the New Economy, creating even more volatility, dips and swings. Once dip riders get nailed by a bigger-than-usual dip, at first they are a bit scared, but continue to ride the dip. When the dip does not recover, they begin to

hope

the next rally will bring them out of the hole.

When the dip goes lower, the anxiety level increases, building into true fear. Their thoughts are filled with, "I am too low to sell now, I must ride this out." As it goes even lower, fear turns to pain, then panic, and they sell all they own to anyone who will buy, which is generally close to the bottom.

We saw the same emotional outburst of panic-selling when the Nasdaq fell from 5100 (point a on the above chart) on March 27 to an intraday low of 3649 (point b) on April 4 (closing at 4148). We saw it again from April 10 to April 17, when the Nasdaq fell from 4475 (point c) to 3227 (point d).

There are those who continue to hang tough, holding their trades, waiting out this big dip as many did in 1987. But there are others who were trading on margin and lost everything. To add insult to injury, they will get whacked big by taxes on last year's profits and be forced to pay with money they no longer have. I feel for these folks, as I am also an investor in my long-term accounts.

Many have asked me to look into my crystal ball and tell them what will happen next. Like any good momentum trader, I don't try predict the future beyond day to day. I just take the cards as they come. I do feel that many of the online traders will return like scorned lovers, but the rise will be slower as everyone rejoins the market with reservation. The Nasdaq could be back to 5000 this year, but I hope we're all a bit wiser.

Ken Wolff is founder and chief executive officer of Paradise, Calif.-based MTrader.com, a daytrading and swingtrading Web site. This column provides general information about momentum trading. TheStreet.com has no affiliation with MTrader.com, and no endorsement of MTrader.com or momentum trading is intended. While Wolff cannot provide investment advice or recommendations here, he invites your feedback at

ken@mtrader.com.