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As an example: Over this past weekend, from Friday close to Monday open, Netflix (NFLX) dropped about 36% in stock price. Going back to July, Netflix was trading near $300, and now it is at about $79. This seems due to some announcements about loss of customers as well as what seems to be perceived by some as strategic blunders.

This strikes me as an incredible drop for such a big, "hot", well-known company that has a volume of ~12 million shares and a market capitalization of ~$4 billion. Those who bought when it was selling for $100 to $300 cannot be pleased with this turn of events.

The question is: How often does this sort of thing occur? Can such a likelihood even be quantified? Are there things to watch out for in assessing the likelihood of a future dive?

I ask because it seems that with swing trading small low-stock-price companies, there is a lot of volatility and big movements are part of what you expect. But one might be tempted to feel a lot more "stable" (safer?) holding shares in huge and profitable companies? But of course, they take sudden dives, too.

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If the company is in troubles, its very likely to occur. Netflix is in big troubles, for several months now. Bad decisions lead to bad publicity and significant customers' loss. If you're tracking the company, you wouldn't be so shocked. –  littleadv Oct 26 '11 at 17:35
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"I don't want to buy any stock where if they close the New York Stock Exchange tomorrow for five years I won't be happy owning it. I buy a farm and I don't get a quote on it for five years and I'm happy if the farm does ok. I buy an apartment house, don't get a quote on it for five years - I'm happy if the apartment house produces the returns that I expect. But people buy a stock and they look at the price the next morning and they decide if they're doing well or not doing well. It's crazy because they're buying a piece of a business." -Warren Buffett –  Eric Oct 26 '11 at 19:48
    
Am I reading it wrong, or are there 3 votes to close? If so, why? What's wrong with this question? Thanks. –  Chelonian Oct 27 '11 at 17:03
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@Chelonian IMHO, the question is OK, but the close votes could be due to (a) editorializing, or (b) the speculative nature of the question, or (c) the fact that there's not likely an objective and quantifiable answer to the specific "What is..." question. I think you need a better title. OK, there. –  Chris W. Rea Oct 27 '11 at 17:12

4 Answers 4

up vote 3 down vote accepted

Certainly no one knows in advance how much a stock is going to swing around. However, there are measures of how much it has swung around in the past, and there are people who will estimate the probability.

First of all, there's a measure of an individual stock's volatility, commonly referred to as "beta". A stock with a beta of 1 tends to rise and fall about as much as the market at large. A stock with a beta of 2, in the meantime, would rise 10% when the market is up 5%. These are, of course, historical averages. See Wikipedia: http://en.wikipedia.org/wiki/Beta_(finance)

Secondly, you can get an implied measure of volatility expectations by looking at options pricing. If a stock is particularly volatile, the chance of a big price move will be baked into the price of the stock options. (Note also that other things affect options pricing, such as the time value of money.) For an options-based measure of the volatility of the whole market, see the Volatility Index aka the "Fear Gauge", VIX.

Wikipedia: http://en.wikipedia.org/wiki/VIX

Chart: http://finance.yahoo.com/q?s=%5EVIX

Looking at individual stocks as a group (and there's an oxymoron for you), individual stocks are definitely much more likely to have big moves than the market. Besides Netflix, consider the BP oil spill, or the Tokyo Electric Power Company's Fukushima incident (yow!). I don't have any detailed statistics on quantitatively how much, mind you, but in application, a standard piece of advice says not to put more than 5% of your portfolio in a single company's stock. Diversification protects you. (Alternatively, if you're trying to play Mr. Sophisticated Stock-Picker instead of just buying an index fund, you can also buy insurance through stock options: hedging your bets. Naturally, this will eat up part of your returns if your pick was a good one).

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The P/E is currently 20. In hindsight, it's easy to see that when it was 50, not long ago, it was very overpriced. They were not adding customers or increasing revenue as they should have to sustain that P/E level.

Probability? I suppose this can happen with any company that has both a high P/E and non-diversified business. Why did you think this company was large and stable? Their marketing blunders simply pricked the bubble level pricing these guys had.

(Disclaimer - I am actually a happy customer of Netflix. For $8/mo, I get 6-8 DVDs and neither spend gas nor time to get them. Others who grew used to free streaming feel otherwise)

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The only problem with hindsight is that when you wanted to go bearish at $200 looking at the same exact fundamental problem, you didn't know it was going to run up to $300. There are ways to mitigate this of course –  CQM Oct 27 '11 at 5:19
    
Sorry, agreed. I use the word "easy" a bit tongue-in-cheek as it's tough to pick tops, or bottoms for that matter. The real question to ask is what expectations are for a company, what drives the P/E (for established companies) or what kind of earnings will a company with low real earnings be capable of. I ask (rhetorically) why MSFT now has a P/E under 10, AAPL 14.5, and GOOG, 20. 2-5 years out will these P/Es have been a sign of what was to come? –  JoeTaxpayer Oct 27 '11 at 12:18

This is a classic correlation does not imply causation situation. There are (at least) three issues at play in this question:

  • The resolution of price changes (A 14 cent stock only has 13 marks between its price and zero).
  • The volume of stock being traded. (See this question)
  • The actual viability of the business.

If you are swing- or day-trading then the first and second issues can definitely affect your trading. A higher-price, higher-volume stock will have smaller (percentage) volatility fluctuations within a very small period of time.

However, in general, and especially when holding any position for any period of time during which unknowns can become known (such as Netflix's customer-loss announcement) it is a mistake to feel "safe" based on price alone.

When considering longer-term investments (even weeks or months), and if you were to compare penny stocks with blue chip stocks, you still might find more "stability" in the higher value stocks. This is a correlation alone — in other words, a stable, reliable stock probably has a (relatively) high price but a high price does not mean it's reliable.

As Joe said, the stock of any company that is exposed to significant risks can drop (or rise) by large amounts suddenly, and it is common for blue-chip stocks to move significantly in a period of months as changes in the market or the company itself manifest themselves.

The last thing to remember when you are looking at raw dollar amounts is to remember to look at shares outstanding. Netflix has a price of $79 to Ford's $12; yet Ford has a larger market cap because there are nearly 4 billion shares compared to Netflix's 52m.

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In general, when companies are regarded as "hot" growth stocks, they are expected to keep up an accelerated level of growth for a good long time. That accelerated growth justifies a high PE relative to a slow-growth stock.

When companies that are supposed to grow miss expectations or (worse) lose money, the markets punish the stock severely... Particularly if the company doesn't make analysts aware of problems early on.

Netflix is a great example of a company bungling a few different business problems, creating a much bigger one in the process. A poorly conceived rate hike killed the reliable cash flow of the company, and that crazy Quixter thing just confused everyone. Now nobody trusts the management. BlackBerry is another example of a high performing company that just screwed up, damaging shareholders in the process.

We're living in a very challenging era today, but growth stocks are always risky by nature -- growing a company rapidly is very difficult.

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