Volatility on Steroids: When Stocks Hit Air Pockets

While In Sickness and Wealth focuses on the healthcare sector, we always try to educate our readers about the nuances of the overall stock market. Newcomers are always shocked when they see certain issues double in price in a day or lose 50 percent of their value in a few hours. With the exception of the penny stock market, and certain small capitalization technology stocks, no sector engenders more volatility than biotechnology. There are several reasons these stocks exhibit the exaggerated price movements:

  • Hot money: They are ground zero for hot money. Hot money is money that is chasing a fad or a promise. It’s highly emotional and doesn’t care too much for the long-run prospects. Speculators, whether they are large hedge funds or small traders, are looking for action… based on either news, or they’re jumping on a short-term trend hoping to catch a quick 10-20 percent move in a short period of time. It may be the prospect of a successful early stage clinical trial for a miracle drug or an FDA rejection of a new drug application. Either way, judgement is swift and violent. Good news sends the stock soaring (example: Sarepta’s stock when they received FDA approval for their muscular dystrophy drug…it basically doubled in a few days). Bad news inflicts untold pain for those left holding shares as they can sometimes lose 50 percent or more of their market value in a day.
  • Market Capitalization: Large cap stocks usually have a far greater number of shares outstanding than other companies. With this comes critical mass. Large pension funds and mutual funds with large amounts of capital need to invest in larger cap stocks. Large cap stocks usually have wide institutional ownership and a great deal of critical mass in the markets; hence, they don’t have gigantic air pockets like a Sarepta or others. Johnson and Johnson is not likely to lose 50 percent of its value in a day (as a holder of the stock, we certainly hope not).
  • Liquidity:  I checked on my Bloomberg terminal the other day to see the bid/offer spread and size (size is the amount of shares being bid and the amount offered) on Sarepta vs. Apple Computer. Apple’s market cap is the largest in the world at $640 billion compared with Sarepta’s $1.6 billion. In addition, at any given moment there are tens of thousands of shares being bid and offered in the market for Apple. With Sarepta, the stock had 100 shares bid and 100 shares on the offer—the minimum possible. If someone wanted to unload 10,000 shares, they’d have to sell right through that 100 lot and probably several levels below that to get the order completed. Now, imagine you are TIAA-CREF (Teachers Insurance and Annuity Association/College Retirement Equity Fund—a giant institution that invests for teachers and college professors and other organizations) which holds 360,000 shares of Sarepta. What if they wanted to reduce their holdings by a third? They’d have to dump 120,000 shares in a market that is basically one hundred up (100 shares bid/100 shares offered). When this sort of thing happens—and it’s more common than you’d think—the stock could plunge dramatically, creating the air pocket effect you see among early stage biotech companies.

Does this mean you should avoid such illiquid, low market capitalization issues? Not necessarily. It depends on your intestinal fortitude. If you crave action and have the financial resources necessary to withstand the air pockets, then you might just make some money. But if you can’t sleep at night and kick the cat because you just lost your vacation money and your spouse is going to be very unhappy… then you should probably play a more conservative strategy. There are plenty of stocks in the market with great prospects that have much less risk and volatility.

Be careful out there!!

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