Anyone who is not a professional share trader can be forgiven for wondering what on earth is going on in the Hong Kong stock market at the moment. For the last couple of months we have endured crazy volatility, with daily swings of 5 or even 10 per cent commonplace. It's a far cry from conditions in the first half of last year, when a 2 per cent rise or fall was considered a wild day in the market (see the chart below). Part of the problem is that the 65 per cent slide in share prices in the 12 months to late October swept a lot of investors out of the market. According to brokers, individual investors make up only about 10 per cent of the volume on the stock exchange at the moment, in contrast to 30 per cent previously. Retail investors are not the only ones scared off. According to HSBC, hedge funds are typically holding between 60 and 70 per cent of their assets under management in cash. Some need liquidity to meet redemptions after a dismal performance so far this year. Others are holding cash simply because their investment strategies have broken down. As JP Morgan strategist Adrian Mowat points out, during October's forced sell-off it wasn't a company's cash flow that dictated its stock price performance but rather the cash flow of its shareholders. As a result, valuation models were rendered useless. Conventional fund managers, meanwhile, are divided. Some, like the portfolio managers at Investec Asset Management, are returning to the market, arguing that equity valuations have fallen to extreme lows and now represent compelling value. Others, like Mark Konyn at RCM Asia Pacific, prefer to hold back, warning that the recent rebound is merely a bear market rally and that stock values do not yet adequately discount the growing risk of deflation. With the market in such a schizophrenic state, participants are seeing some unusual effects. Greg Lee, equity sales director at UBS, points out that as share prices have fallen, clearing and settlement costs - which are based on numbers of shares, rather than their value - have risen in relative terms. As a result, some high-volume trading strategies like statistical arbitrage are no longer cost-effective, which has tended to reduce liquidity to hard-to-find pockets. With volatility up and fewer players in the market, bid-offer spreads have widened. David Rabinowitz, executive director at UBS responsible for execution, estimates that in May last year the total cost - spread plus market impact - of buying HK$100 million of Hang Seng Index stocks was 0.19 of a percentage point. Today the cost is 0.62 of a percentage point, more than three times. As a result, buying and selling blocks of shares has become both more difficult and more expensive, which in turn exaggerates volatility. 'It's self-fulfilling,' says Mr Lee. 'Volatility is absolutely being driven by widening spreads.' In response, investors have become much more short-term, partly because in conditions of heightened volatility they tend to hit their price targets more rapidly. Mr Lee points out that it took nearly two years, from September 2001 to August 2003, for HSBC's stock to climb from HK$75 to HK$100. In October it took just two trading sessions for HSBC's shares to cover the same price interval in reverse. One effect of such extreme volatility, coupled with the reluctance of buyers and sellers to meet halfway on price, has been to concentrate volumes in the stock exchange's closing auction - the period introduced earlier this year to match unfilled orders at the end of the day. In recent weeks, as much as 10 per cent of daily trading volume in some stocks has occurred in the closing auction. That's good for professional fund managers, who get to execute large orders at a fixed price, but it may disadvantage retail investors whose orders have been filled during ordinary trading. As some private investors have boasted recently, you can make a killing in this market. But be careful, if you don't know what's going on, you could just as easily get killed.