Stock sell-offs are tough for long-term buy and hold investors to swallow. But they are a necessary and natural element of a functional marketplace. Laws of supply and demand and investor appetite fuel both uptrends and downtrends. As investors, it's important to be aware of both of these phenomena so that we can plan accordingly.
Sell-offs also conjure up a special vocabulary of finance and investing words in the media that may be unfamiliar. Here is a cheat sheet of some of that lingo for the next time you find yourself in a downdraft.
- Stock sell-offs are a necessary and natural element of a functional marketplace, even if they are tough for long-term buy and hold investors to swallow.
- Sell-offs also conjure up a special vocabulary of finance and investing words in the media that may be unfamiliar, such as volatility, buying the dips, and short selling.
- Knowing the language of financial markets can only make you smarter and a better investor.
In general, a correction is a 10% decline of the price of a security, market, or index from its most recent high. A correction should not be confused with a crash or just a bad day in the markets; these happen fairly frequently and can last anywhere from a couple of days to several months. Stocks can be in a correction before the index they are included in falls into one.
Technically speaking, volatility is a statistical measure of the dispersion, or returns, for a given security or market index. That's another way of saying it's a measurement of change (or beta) of a security or index against its normal patterns or benchmarks it is weighed against. In the stock market, one way of measuring volatility is to look at the Chicago Board of Options Volatility Index (VIX).
There are many other ways to measure volatility, depending on what you are looking at or measuring. If you think of it as a measurement of the rate of change that reflects uncertainty or risk, you are on the right track.
Implied volatility refers to the estimated volatility of a security's price and is generally used when pricing options. In general, implied volatility increases when the market is bearish—when investors believe that the asset's price will decline over time—and decreases when the market is bullish—when investors believe that the price will rise over time.
Basically, short selling is a bet that a security or index will decline wherein a short seller borrows shares to offer them for sale. The idea is to sell such shares, of which the short-seller has no ownership, at a higher price hoping that the price falls by the time the trade needs to be settled. That would enable the short-seller to acquire shares at the lower price and deliver them to the buyer, making a profit equaling the difference in prices. While, if done right, short selling could be profitable but could amount to massive losses if the trade goes the other way. It is definitely not a strategy for beginners.
A circuit breaker is like the breaker box in your basement. However, this one can shut off the juice at the major securities exchanges. Exchanges like the New York Stock Exchange (NYSE) and Nasdaq are sometimes compelled to flip the switch when there is too much of an imbalance between sell and buy orders. With more and more trades being pushed through computer algorithms, those imbalances can be more frequent. They last anywhere from a few minutes to several hours, but it's all in the name of smoothing out the order flow so markets can effectively match buyers and sellers.
Buy the Dips
"Buy the Dips" is trader slang for buying securities following a decline in prices, with the inkling that they have fallen for no apparent reason and should recover and keep rising in short order. It's kind of like an unexpected sale at your favorite retailer, except you think the value of the things you buy on that sale day will get more valuable over time. It doesn't always work out in the stock market, but people like saying it.
In a way, you can think of capitulation as ripping your computer off the desk, hurling it across the room, and throwing the mother of all tantrums... but really its another way of saying that you can't bear the losses anymore in a particular security or market and you are going to cut your losses and sell. When markets or a particular stock sells off in heavy volume, many investors are tempted to abandon ship and sell their stakes as well, or capitulate. That only exacerbates the losses.
The recent market sell-offs have been attributed in part to fears about rising inflation. Simply put, inflation is the rate at which the level of prices for goods and services rise which can drive the purchasing power of a currency lower. The Federal Reserve pays particular attention to rising inflation when it sets overnight lending rates or the Federal Funds Rate, as it is known. Since the Fed has been raising rates of late and plans to continue to do so a few more times, at least, it makes borrowing costs more expensive which can impede growth and therefore profits. It may sound complicated, but you can understand the relationship between interest rates and stock markets.
Rising bond yields are also being blamed for the sell-off in stocks. As the Fed raises overnight lending rates and the yield, or return, on U.S. Treasury bond prices rise, it makes them more attractive to investors, large and small, who are looking for a safer and less volatile place to put their money than stocks. Bond yields have been so low for so long, but they are starting to creep higher, drawing more money to them and away from stocks. Take a deeper look at why yields matter.
Tariffs are increased duties that are levied by countries on goods they import to protect domestic industries. These levies make the imported goods less attractive to domestic consumers. But even as this is expected to be a shot in the arm for the domestic economy, it has other consequences like upsetting trade partners who may retaliate, setting off a trade war. When this occurs with a significant trading partner, the future of large corporations that conduct business in those countries comes under question, putting pressure on the stock markets.