Algorithmic Trading is Responsible for Major Market Volatility
As someone who started on Wall Street only to be let go and replaced by algorithmic-based trading, I can completely understand the allure: it's cheaper, more efficient, removes all the human-related issues, and it's always around to work for you. There is no doubt that algorithmic trading was a marvelous invention and revolutionized the financial world. However, it isn't without its own major flaws...which become very apparent in times of great volatility.
While many of us hoped the market would rally forever, little things here and there have caused some investors to get nervous and initiate the sell-off. The market has since bounced back and declined and bounced back several times since the start of 2018, but some on Wall Street have made a keen observation: volatility has surged since the market has been run by computers.
Algorithms are helpful, but they can lead to frequent and severe bursts of volatility. Why? Well using rules-based investment strategies can lead to the complete removal of emotions from investing...including the emotion to tough-it-out despite the panic. As a result, more selling can happen when large amounts of selling happens, and more buying can happen when the market is surging. The magnitude of the change is just greater.
Below are some observations from Investopedia on the incidents and potential results that algorithmic trading can have on the overall market now and in the future. The end result? Be vigillant and understand that machines don't understand the relative long-term positive bias that the stock market holds.
'Herd Behavior On Steroids'
As alluded to by Todd Rosenbluth, algorithmic trading, also called program trading, can create self-reinforcing trends that unfold at lightning speed, far beyond the ability of human investors and traders to keep up and undertake evasive action. In fact, some programs are designed precisely to follow trends, and the recent correction in stock prices was intensified as these algorithms suddenly shifted from buying to selling."
It's just not normal, this action [was] like a rubber-band broke," according to Keith Lerner, chief market strategist at SunTrust Private Wealth Management, in remarks to Barron's. Momentum investing, in which investors chased the hottest stocks, was a factor in the market's rapid rise. Now the opposite effect may be in play, with selling pressures accelerating."
The truth is that the market is just as irrational and divorced from fundamentals on the way up as on the way down. It is the nature of the markets more so today than ever, as a result of the computerized high-frequency trading strategies of the Wall Street wise guys. What we've watched this week is herd behavior on steroids," is how Washington Post business and economics columnist Steven Pearlstein puts it.
'Poisonous Feedback Loop'
Indeed, the problem is heightened by the fact that many of the investment firms that create trading programs and algorithms follow similar, if not identical, decision rules. The key episode in the 1987 stock market crash, the Black Monday drop of 22.6% in the Dow Jones Industrial Average (DJIA), was the result of a "poisonous feedback loop" among these programs, as an earlier Barron's article described it.
In the ensuing years, trading algorithms have become increasingly more pervasive, controlling an increasing percentage of total transactions, and thus adding to the dangers.
A recent study finds that nearly $8.8 trillion of financial assets worldwide were controlled by trading algorithms as of 2016, and that this figure is projected to grow at average annual rate of 8.7%, reaching $18.2 trillion by 2025, according to Business Wire.
Meanwhile, data from JPMorgan Chase & Co. found that quantitative and passive investing strategies account for about 60% of all equity assets, a figure that roughly doubled in ten years, per Bloomberg. By contrast, the same data indicated that only about 10% of equity trading volume now comes from human individual investors and discretionary investment managers. Passive strategies include index funds, whether structured as traditional mutual funds or as ETFs.
What About the Opposing View?
Defenders of automated trading systems cite several key points in their favor: consistency, discipline, elimination of emotion, and analytical rigor. They assert that such programs bring more logic into the trading and investing process. Also, defenders of high speed trading see economic logic in market prices adjusting quickly to changing fundamentals, or changing perceptions of fundamentals.
On another front, in response to the experience of 1987, major trading venues such as the New York Stock Exchange (NYSE) have implemented so-called circuit breakers or trading curbs that temporarily halt trading in the midst of a steep selloff. The idea is to stem a panic, and let market participants step back and take a breath.
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