This year, we have seen several days where stocks “sell off.” The losses in value are tough for most long-term, buy-and-hold investors to stomach. However, they are an entirely natural and necessary byproduct of a properly functioning marketplace. It all goes back to the law of supply and demand: investor appetite can fuel more gains or lead to sell-offs.

Sell-offs exist in a world of terms and statistics that can be confusing – volatility, correction, market fluctuation, short selling, circuit breaker, capitulation, etc. Today I want to break these down to help dispel some of that confusion.

Volatility

Few things go on continually increasing forever, except your age – and even that will stop at some point. For every action there’s a reaction, and for many market increases, there’s a decrease waiting in the wings and vice versa. Volatility is a statistical measure of the returns for a given security or market index – in other words, the change of a security or index against its normal trading patterns or benchmarks.

One way to measure volatility is to look at the stock market ticker “VIX,” the Chicago Board of Options Volatility Index, which changes by the second. Think of volatility as turbulence when you fly – sometimes you bounce up and sometimes you bounce down.

Correction

A correction is a price decline of around 10 percent in a group of stocks such as an index (think Dow 30 or S&P 500) or an individual stock (think Facebook, IBM, or 3M) from its most recent highest trading price. This is not to be confused with a crash or your average bad day in the market. Corrections happen frequently and last an average of 71 days, although there’s no way to know if a correction will last a few days or a few months.
“Buy the Dips and Sell the Rips”
This is trader slang for buying securities declining in price. The concept of buying dips is based on market fluctuation. Because the markets are volatile, any given dip in prices should eventually rise back up. By purchasing securities right after a dip, investors are essentially buying shares at a discounted sale price.

This type of price movement can happen during either a bull or a bear market, when it is known as either a “bull market rally” or a “bear market rally.” Typically, a rally will generally follow a period of flat or declining prices.

Short Selling

Not everyone loses money when a stock price goes down. If you felt an individual stock (e.g., Radio Shack, Enron) or an index (e.g., Dow Jones or S&P 500 in late 2008) was declining in value you could place a bet. The person betting the decline – known as a “short seller” – borrows shares to offer them for sale.

The idea is to sell the borrowed 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. This allows the short seller to acquire shares at the new, lower price and deliver them to the buyer, thus making a profit equaling the difference in price.

Please note: when done correctly, short selling can be very profitable, but it can also amount to massive losses if the trade goes the other way and prices increase. Essentially, don’t try this at home – it’s not a strategy for beginners.

Circuit Breaker

Picture a circuit breaker. If you flip one circuit, the power goes off to part of your house. If you flip the master switch, you shut the power off for the entire house. Now imagine you flip a switch for the stock exchanges. This type of “circuit breaker” can shut off the juice at the major stock exchanges.

Exchanges like the NYSE and NASDAQ are sometimes compelled to flip the switch when there is a large imbalance between sell and buy orders. With an increasing number of trades being pushed through by quant traders (computer algorithms), those imbalances can be more frequent and severe.

The “power outage” may last anywhere from a few minutes to several hours, but it’s all in the name of effectively matching buyers with sellers and smoothing out the buy/sell order flow.

Capitulation

Derived from a military term meaning “surrender,” capitulation occurs when investors give up any previous gains in stock prices by selling equities to get out of the market. It involves extremely high volume and sharp declines, and often is accompanied by “panic selling.”

After capitulation selling, many traders think there are bargain buying opportunities. The belief is that everyone who wanted to sell a stock for any reason, including forced selling due to margin calls, has already sold out of their positions. The price should then, theoretically, reverse or bounce off the lows. Some investors believe capitulation is the sign of a stock market bottom.

How Does This Impact My Portfolio?

While sell-offs and these other market behaviors are completely normal, it’s easy for investors to become anxious at the thought of losing funds or experiencing a bad market. At Manchester Financial, our Investment Committee considers market circumstances and makes changes to portfolio models in Manchester’s professional management of client accounts.

“All investing involves risk, but at Manchester Financial we’re constantly evaluating the market climate so we can help clients make smart investment decisions” said Manchester’s President Robert Katch, who serves on the Investment Committee.

“Through Manchester’s Powered by Planning® process, clients can have confidence in their future,” said Alan Hopkins, our Chief Economic Strategist and another Investment Committee member.

All financial trading instruments have sell-offs. They are a natural occurrence from profit taking, short selling or portfolio turnover. Healthy price uptrends require periodic sell-offs to replenish supply and trigger additional demand. Minor sell-offs are considered “pullbacks.” Pullbacks tend to hold support at certain levels like the 50-day or 200-day moving average – but that’s pretty technical.

When a sell-off continues for an extended period of time, it can be a sign of a potentially further and dangerous market reversal leading to a correction (10 percent decline), full-blown bear market (decline of 20 percent or more) or, worse yet, a crash like the Great Depression and Great Recession.

The new millennium has seen two bear market sell-offs. During the tech bubble of 2000 to 2002, the S&P 500 fell 58 percent. The second bear market sell-off occurred during the housing bubble and global financial meltdown from 2007 to 2009, when the S&P 500 dropped 57 percent. The average bear market occurs every 3.4 years.

Just talking about those times can be upsetting to some, so let’s enjoy the current bull market that has been going on since early 2009, and hope the markets continue to act normally.

Markets making you nervous? Set up a time to talk.