Understanding Stock Market Corrections

When markets correct, individuals with Margin loans are forced to liquidate their positions to pay back the house. This exasperates the losses in a down day. To pay back Margin Calls, more selling has to be done. The market shows a loss because for every dollar owed investors must sell three dollars worth of assets. I’ll try to illustrate clearly the situation.

Investor Mrs. A has $50 to invest. She wants to buy 1 share of XZY ETF at $50. When she does, she receives notice from her broker that the house can lend her another $50 to buy a second share. She thinks why not, if XYZ ETF is a good buy at $50, it’s better to buy two instead of just one. She borrows $50 to buy another share of XZY ETF stock. Now Mrs. A owns 2 shares of the XYZ ETF. She owes the house for her margin loan, $50.

At some point, the market begins to sell off. The shares of XYZ ETF stock Mrs. A owns, has gone from $50 each to $30. Mrs. A gets a House Call to repay the $50 she owes the broker-dealer, her lender.

She doesn’t have the cash, so to meet it, she must sell into the market. She enters a Limit Order to sell XYZ ETF at $30, but there are no buyers at that price. In order to comply with the lender, she must change her order. She changes the order to a Market Order, since the lender insists that she must sell and pay back her loan. The Market Order she places to sell her XYZ ETF shares gets executed at $20. After both shares she owned are sold at $20 each, she receives nothing for her sale after the house gets paid $40 and since her debt was $50, she’s left owing her broker-dealer $10, which she still must pay. Mrs. A now has an account in what is called negative equity.

If she held IBM stock, selling IBM would hardly trigger any across the market sale. Everyone would see IBM having a down day. However, selling ETFs triggers across the market selling, as ETFs hold the stocks of tens of companies, which translates into large dumping of company shares across the Dow Jones, the Nasdaq and the S&P indices. These are large companies, middle sized companies and small companies. Observers see a sea of red across the boards. This is a pivotal occurrence. It’s what took place today, Monday, February 5, 2018 and what took place Friday, February 2, 2018.

The pattern of buying on credit, called Margin, is multiplied thousands of times by thousands of investors. It’s why their selling into the market becomes a nightmare for all investors. The lack of buying when house calls are triggered aggravates market losses.

Coupled with House Call selling, we know the market is severely moved by very large institutional traders: banks, insurance companies, government agencies, municipalities, counties, states, large corporations nationally and internationally around the world, all with technology controlled by algorithms that are programmed to sell at certain points automatically, their selling in turn triggers other algorithmic programs to sell because other algorithmic parameters get triggered and so on down the line.

As these thousands of orders hit the market at the same time, there are fewer and fewer buyers, which trigger sales at lower and lower points.

In other words, what could have been an orderly market selling becomes crazy panic selling. This is what happened today, Monday, February 5th at 3:11 PM. The market which at 3 o’clock was -650 points, unexpectedly eleven minutes later dropped to -1,590 when enough buyers for those massive sell orders were not present. It leveled off a few minutes later when certain algorithmic buys entered the market, as algorithms work on the down side as much as on the upside, but the panic was triggered. People who never wanted to sell at lower prices were executed at those levels because the House Calls had to be met.

Tomorrow should be another day where more Margin Calls are met. Margin Calls tend to end after a couple of down days, after loan repayment is complete and investors are stripped. Investing on Margin is not advisable for individuals without financial assets to back their market losses.

As House Calls are met, the Margin repayments are finished. Often, algorithmic buying begins to mend the wounded market. Nonetheless, the recovery should be less dramatic, but history proves recovery follows market corrections, albeit historic returns are unrelated to future performance.

To recap, tonight every single factor that seemed promising about the companies and their prospects for continued growth remains. Nothing changed since Thursday last week. It’s scary to watch the sell-off. I know. I’ve been here many times before and the shock is unpleasant. It affects everyone, but it affects everyone differently.

If you decide to bear the pain, there are a couple of things that can be done to take advantage of any market weakness. Stocks that were not at these price levels Thursday last week are available at bargain basement prices. With fundamentals of the market intact, the companies with lower pricing after a sell-off still will earn money. They will still pay dividends. Their products will still be sold around the world.

With US workers keeping more of their money on account of the lower taxes levied, there will be more economic activity, more products will be sold, and more sales made will trigger new gains, and so on. Investors could buy some of these companies directly or they could buy ETFs where these companies are part of the portfolio when the market settles before they return to higher prices.

There are also Options to figure in the scheme. You could buy Calls on large company stocks that went severely down over the last two days. However, to go into Options as a hedge, inexperienced investors must sit down with their financial adviser. Responsible advisers must know that their clients understand how Options work, their risks and their possible rewards; without ample evidence of a full grasp of options trading, it’s not wise to engage in this type of hedging.

Always remember that everything invested in the market has a potential to lose some money or all of the money equally as much as the potential to make some money or tons of money.

This too shall pass.

About Francisco

Born in Cuba; political exile; American by choice; polyglot; father of four, grandfather of two; occupationally semi-retired; reader; writer; lover of mankind and nature; searcher of truths; hungry for wisdom; open-minded; romantic realist; critical thinker, enemy of despotism, government abuse, and inequality; believer and faithful; social liberal, fiscal conservative; in a quest to unmask the hypocrisy and the corruption enslaving overwhelming numbers of God's creatures around the world.
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