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The Nature of Trading in Volatile Times

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When the next market shock happens, you likely will have only moments to react. Will you be ready?
This chapter is from the book
  • “You always need a catalyst to make big things happen.”
  • —Jim Rogers1

The market is losing $718 million per second. The clock is ticking. Millions—no, billions—down the drain. Your positions are getting eviscerated. Down, down, down. What should I do? What can I do? What is going on?

This is not a scenario out of a movie—it really happened during the Flash Crash of May 6, 2010. Considering the complexity of the modern market, it is a matter of when, not if, it will happen again.

In a market where high-frequency traders (HFTs) account for 84% of U.S. stock trading volume, how can you make money?2 In a world of uncertainty, how can you minimize risk and maximize profits?

What moves stock prices? What moves the overall stock market? How can you profit, given the catalysts precipitating sudden sharp changes in stock prices? This book answers these questions and more. It is filled with numerous real-life examples to illustrate both the potential profit opportunities and risks that market shocks induce. From the actions of corporate executives to the rulings of regulators, from earnings announcements to merger deals, from lawsuits to settlements, from macroeconomic reports to government policy actions, and from elections to terrorist actions, Shock Markets takes you inside the market to understand what happens and why. This includes analysis of the market during fads and fashions, bubbles and crashes, and market crises. It also explains how to create and implement a solid trading game plan.

Why Study Market Shocks?

Market shocks illuminate reactions in the market to news. Studying past market shocks is key to understanding and reacting to future market shocks. When the next shock happens, you likely will have only moments to react. Will you be ready?

The analysis of market shocks enables you to isolate the market’s reaction to a specific news event. Moreover, the analysis of the market reaction to a specific news event provides clues to the trading themes driving the market.

Financial markets can be tranquil or turbulent. Both are characterized by periodic shocks. Shocks create risks as well as profit opportunities. Extreme price moves are more common than you might expect. Numerous sources of shocks exist. How markets react to shocks contains important lessons for market participants. Many successful traders argue that they make most of their profits from only a handful of trades each year. Gradual profits (or losses) arise from riding a trend. However, quick profits (or losses) arise from sudden, sharp shocks to market prices. That’s why understanding market shocks is so important.

Individual stocks are more volatile than the market as a whole. What might constitute a market crash (down 20% or more), or a major rally, can occur in a single day for individual stocks. This means both risk (for those unprepared) and opportunity (for those who have prepared to take advantage of market shocks).

Market shocks can be small, or extraordinarily large. Take the example of Medbox, a company that creates medical marijuana dispensing machines. In mid-November 2012, after several voter referendums sought to legalize marijuana at the state level, it saw its share price rise 3,000%,3 surging from a market capitalization of $45 million to up to $2.3 billion.4 Although the stock surge from $4 to $215 was transitory, the price remained significantly elevated from $4, spending the month after the shock trading between $20 and $100.

Market shocks happen every day. Although this book includes some examples from the more distant past, the focus is on more recent examples for two reasons. First, the reactions to a given shock may change over time, so recent examples give traders a better idea of the likely market reaction than older examples. Second, recent examples are more likely to be both relevant to and more easily understood by today’s trader. The examples considered are by necessity illustrative rather than exhaustive.

In today’s globally connected world, shocks in one country can spill over and spread across the world. Capital flows easily and quickly around the world. Still, the U.S. represents 45% of world equity value and is a prime candidate for study.5 This book includes examples of shocks from around the world, although many of the examples involve U.S. traded firms.

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