Crash course

Friday was yet another grim session for Germany's main share index, the DAX. The chart at the Frankfurt Stock Exchange closed 2.19 percent in the red, despite briefly flirting with positive numbers early in the day.

That's what traders call a "dead cat bounce," because even if the plunge to earth was so great that it killed the poor imaginary moggy, its lifeless body might still rebound briefly on impact.

None of this is news to economic historian Werner Abelshauser. "We've known this since the crash in 1929," he told Deutsche Welle, referring to the Friday of that year when the stock market crashed and helped trigger the Great Depression.

There are rational explanations for stock market volatility, but technical aspects and psychological effects also play a role.

Fat fingers flog dead cats

The so-called "fat finger" seems to be, once again, behind the most recent falls on the stock markets. If a trader's finger gets stuck on the keyboard or mistakenly presses down a key next to the one he actually intended to hit, a simple share transaction can go horribly awry: the trader unwittingly multiplies the order, the share price gets knocked down, making the company behind it almost worthless.

Easily done in the heat of the moment, or, if the trader is indeed on the chubby side, his fingers may well be too fat to cope with the keyboard.

In May 2010, the markets on Wall Street took a massive and confusing one-day drop - falling by a record 9 percent at one point, before rebounding somewhat - that's believed to have been a fat finger anomaly. This loss, representing almost a trillion dollars, was widely rumored to involve someone selling one billion widely traded stocks, not the one million he or she intended to let go. There is just one key between "b" and "m" on a "qwerty" keyboard, after all.

Most traders would deny such rumors publicly, saying such a slip is unthinkable, but who likes to admit their fallibility, especially when they're already under fire?

The problem is that such mistakes can easily and automatically be compounded. Many investment institutions install so-called "stop loss" functions in their funds. If the price of a stock drops below a preset level, then that stock is automatically sold. It's a loss-minimizing stratagem that makes good sense, but it can set off devastating chain reactions. Remember, the more a stock is sold, the further its value sinks.

Falling knives killing cats

Now the psychological effects can come into play. At the sight of nose-diving share prices, many traders retreat to one of Wall Street's favorite proverbs: "Never try to catch a falling knife." This conventional wisdom is simple enough, but in financial terms the saying is understood to mean that if you try to guess when a plummeting stock is going to bottom out and rebound, you're taking an almighty risk.

But if everyone thinks this way and no one reaches out to try to catch the knife, then obviously the stock will keep on falling, and you're left with another dead cat - that may or may not bounce.

The market antidote, so to speak, is what traders call "imagination." Admittedly this kind of imagination can't revive a dead cat, or certainly not all the dreams of a positive future that the stock might once have had. Imaginative traders might say to themselves (correctly, if they're good at their job): "Ok, this stock is not at its true value now, but it will get to that value after I buy many shares, prompting others to follow suit."

Dropping the knife, not catching it

But there's scope to profit from both an optimistic and a pessimistic imagination on the markets. This is where we dive into the murky realm of short-selling, where a trader doesn't try to catch a falling knife, but instead tries to tip it off the table and send it earthwards.

Unregulated hedge funds often short-sell stock, selling shares that they don't own against a pledge to buy them up at a later date. Provided the price has dropped in the interim, this practice can prove very profitable. This is the kind of speculation that can either worsen existing crashes or even set fresh ones in motion - and that's why it's now in the sights of several European governments, some of whom have placed temporary bans on the practice with certain types of stock.

For economist Werner Abelshauser, dead cats, falling knives and a lack of imagination are not new phenomena, but he told Deutsche Welle that one thing is different in the current decline. Namely that politicians are no longer able to intervene with the same power as in the past. Abelshauser said governments could have reacted to prevent the US sub-prime mortgage meltdown and the collapse of the Lehmann Brothers bank at the beginning of the financial crisis - but added that is no longer an option. Having taken on so much debt after the event to try to ward off recession, their coffers are now empty.

"This debt has now limited their ability to react," Abelshauser lamented.

Author: Dirk Kaufmann / msh
Editor: Susan Houlton