Volatility and volume may be at the cornerstone of a successful trading strategy today. Nasdaq market makers, pummeled by wild movements in stock prices, seek to catch the profitable swings. The concept seems simple.
Not all buy-side traders, however, see the concept in such a simple light. Volatility, some of them say, is a heavy burden.
Portfolio managers would normally cheer whenever their stock picks posted huge upward price movements. But the lightning speed at which some stocks today are rising and falling – and rising again – can make cheering seem premature.
"The stock swings are huge," said Barbara McFadden, a trader at Peregrine Capital Management in Minneapolis. "It doesn't matter whether I am buying or selling. My first report is going to be a point from where I went into it."
"The institutional trader must be disciplined to deal with the hour-by-hour swings in stocks," advised Thomas J. Bardong, head trader at Alliance Capital Management in New York. "The trader must have the ability to handle smaller [amounts of] order flow, which either directly to the floor or through the machines, can move stocks sharply on an hourly basis," he added.
What's happening? Nobody knows for sure but in the so-called New Economy, old-fashioned valuation tools do not help as investors pour disproportionately large sums of cash into technology issues. Those stocks have certainly helped propel the Nasdaq composite index above 5,000.
The accompanying volatility, however, has been as unexpected as it has been profitable for some investors.
Walter Zagrobski, a portfolio manager at Appleton Partners, a money management firm in Boston, predicted that the stock market, especially Nasdaq, will remain excessively volatile until a large number of the New Economy stocks experience a considerable setback.
But the Old Economy stocks are not exactly out of favor, as a recent rally fuelled by traditional blue chips seemed to illustrate.
"The discipline for the institutional trader," Bardong said, "is not to follow the stock down, but to realize that the stock will settle down and move back to where it was before. That's the newest challenge that the institutional trader has to deal with."
Taking the Blame
Several trading pros stress that some of the daily percentage swings are modest. These pros add that the percentage swings tend to seem worse than they really are, because of three-digit point swings reflecting the climb in the indexes. But they acknowledge that on many days the volatility can be as treacherous as a hurricane.
In January, for instance, the Nasdaq Composite Index moved by more than two percent in 10 out of 21 trading days. (During the period from 1988 through 1995, there were only 10 such days).
Some experts think the volatility is a sign of a coming bear market. But others are not so sure. In this New Economy, they say, there is room for even more spectacular gains in the technology sector where most of the biggest upward price movements have been registered.
Many blame the volatility on active individual investors, empowered by computers, ducking in and out of the market. Ten years ago, the retail investor held the average Nasdaq stock for about two years. Now, it's for no longer than five months. Day traders account for approximately 15 percent of the Nasdaq's daily volume.
Sam Ginsburg, senior managing director of capital markets at Gruntal & Co., said recently that the increasing number of retail investors buying Nasdaq stocks for the short-term is driving the market. "Every day is a new day," he said. "Nothing is surprising to us. You have to live in this market minute-to-minute. This is not an owner's market. This is a renter's market. We rent stocks. I don't own them."
Investing habits, of course, can be somewhat unpredictable as the recent blue-chip rally showed.
Although there are about 7,000 full-time day traders, there are a significantly greater number of online investors who occasionally day trade.
In the past year there has been a sharp rise in the number of retail investors who trade online. In 1998 there were 2.2 million households trading online, according to Forrester Research in Cambridge, Mass. In 1999, there were 3.1 million. That's an increase of almost 50 percent. Forrester projects that, by the end of this year, the number of households trading online will grow to 3.8 million.
(Meanwhile, some institutional money, prodded by the extraordinary gains in technology issues, is joining the technology investing gold rush even though it defies the conventional wisdom of many money managers.)
Generating Momentum
Hans Stoll, a professor of finance and director of the Financial Markets Research Center at Vanderbilt University in Nashville, Tenn., said the retail investor is playing a major role in stirring up volatility in Nasdaq. "A general trading public is jumping on bandwagons and generating momentum in stock prices," he said.
Today, news and rumors are spread through online chat and message-boards, e-mails and financial-related web sites. The small investor now has practically the same access to information that once was available only to Wall Street professionals. And many of these individual traders are quickly acting on this information on a daily basis – whether it's accurate or not.
Matthew Andresen, president of Island ECN, which is popular with day traders, bristles at suggestions that active individual investors are the culprits for today's excessive volatility.
"Volatility is inversely proportional to liquidity," Andresen said. "The best way to control volatility in the marketplace is to ensure ease of entry and exit. As long as people are able to get into the market and know they can get out, you will not see the panic that ensued from point drops in previous markets."
While the Big Board generally is less volatile than Nasdaq, it too has been experiencing more sweeping stock price activity. Day traders, says Bardong, are playing a role in this volatility.
Baby Boomers
Meanwhile, a growing number of baby boomers are shifting part of their nest eggs from mutual fund investments into the high-flying tech stocks, according to some studies.
"Some are buying on momentum or buying symbols," said William Rothe, former head of Nasdaq trading at Deutsche Banc Alex. Brown in Baltimore. "They have no idea what the underlying company does nor do they care."
Although equity mutual funds took in an estimated $170 billion last year, that's 30 percent less than two years ago.
Where has some of the money gone? Into stocks like Yahoo!, Cisco, Lucent, Oracle, Qualcomm, and Vodaphone. Many of these trades are being placed from personal computers via the Internet.
Said Bardong: "Let's say I am selling XYZ stock at $70 and volume in the stock is 3 million shares. Then all of a sudden on 20,000 shares I'll see the stock go from $70 down to $68 3/4. It goes down 1 1/4 on 20,000 shares. That's a lot of the day traders coming in."
Bardong said the Big Board specialist does not know which size order he is looking at. "So he might have two machine orders that come in that say, sell 10,000 at the market.' The stock is going to get knocked down," he explained.
Finding Other Reasons
Could there be other plausible explanations for the excessive volatility we are seeing? Theories certainly abound. Short selling is one of them.
While day traders and other small investors can tap into the same financial news available to the pros, they must abide by distinctly different short-selling rules. Unlike broker dealers, retail customers must make arrangements to borrow shares of a stock when they sell that stock short.
Junius Peake, a professor of finance at the University of Northern Colorado in Greeley, Colo., thinks this may be adding to the market's increasing volatility, especially with Internet and high-tech stocks.
Soon after some Internet companies issue public stock, the value of the shares traded in a single day may amount to two to three times the issuer's total market capitalization, Peake said.
Let's say, for example, there are 30 million shares outstanding but only 10 million available in the public market. The other 20 million shares are insider stock. "That stock may trade 30 million shares in a day. But how can that stock trade 30 million shares when there are only 10 million in the float?" Peake asked. The answer, he said, may be found among broker dealers who short the stock without having to actually borrow the shares. "They [the broker dealers] are not really trading the stock," Peake said. "They are just playing with numbers."
Peake said that current excessive volatility could possibly be tamed if broker dealers were required to play by the same short-selling rules as the general investing public.
Another academic, Robert Schwartz, professor of finance at Baruch College's Zicklin School of Business in New York, has a different theory. He blames market fragmentation and the difficulty in achieving consistent, price discovery.
Schwartz said the underlying problem is that there is no way to obtain consolidated information about stock orders. Even a centralized limit order book would not eliminate this dilemma, Schwartz said, because a lot of orders are executed via upstairs trading desks.
"There is not a consensus of prices that investors have confidence in," Schwartz said. "So they then start making bets on the prices." He said that momentum traders and day traders are "hopping on the train whether it's moving up or down."
No Fundamentals
Meanwhile, Ian Domowitz, the Smeal professor of finance at the University of Pennsylvania, said day trading and market fragmentation have little to do with generating excessive volatility.
Domowitz said the wild price swings, especially with the dot-com stocks, can be attributed to the "dispersion of beliefs" among small investors, as well as professional money managers and traders, about the value of these new issues. Domowitz said, unlike well-known companies with long histories of performance and management, the dot-coms bring to the marketplace none of these fundamentals.
"Since there is very little known about these companies," Domowitz argued, "there is very wide dispersion in transaction prices. Very wide transaction prices are what is called a lot of volatility." He added, "If you have no consensus about value, there can be no consensus about price. Everybody believes something different."
That's cold comfort for the troops coping with volatility on the buyside.
