When the stock market turns especially volatile, algorithmic trading often gets the blame, and usually for good reason in my opinion. There is no doubt that algorithmic trading is contributing to the current historic plunge in the stock markets. So, let’s talk about it.
The use of algorithmic trading is not new, but it has proliferated hugely over the last decade. Big banks, brokerages, hedge funds, institutional investors and many high-frequency traders use computer-driven trading algorithms routinely to guide their decisions to buy or sell, and when. And it’s not just limited to stocks: Algo trading is used in other markets including bonds and currencies, among others.
Think of it as trading on autopilot: If the market falls by a predetermined amount, the algorithm signals to sell more. The opposite can be true when the market is rising with new buy orders issued when the market climbs to certain pre-set levels.
A 2014 study claimed that one positive impact of algorithmic trading is that it makes stock markets more liquid and efficient, and maybe that’s true. On the other hand, algo trading can hide the identity of large buyers and sellers. Some brokerages and other large traders use algorithmic trading to split up orders so the size of their trades will not be observable.
Market makers generally agree it was largely algorithmic trading that sent stocks to record high after record high in the last year. Most also agree that algo trading is a big contributor to the current historic decline, which finds the S&P 500 Index down almost 30% from the record high as of yesterday’s close.
So, what is algo trading? Simply put, algorithms are complex math equations used to program computers to make buy and sell decisions. They come into use in a number of industries. On Wall Street, traders employ algo trading to buy and sell stocks automatically. Algorithmic trading extends “momentum” trades as stocks make a big run.
Many link algorithmic trading with stock market volatility and, in this case, triggering repeated sell orders. A prior example was the “Flash Crash” of May 2010, which wiped $860 billion from US stock markets in less than 30 minutes.
Algorithmic trading may also be triggered when there’s a jump in the “VIX Index,” a measure of anticipated market volatility. The VIX Index is the popular name for the Chicago Board Options Exchange’s Volatility Index, a widely followed measure of the stock market’s expectation of volatility based on S&P 500 Index options. Take a look at this chart:
The green line is the S&P 500 Index and the red line is the VIX. In general, when volatility rises, the value of the S&P 500 Index goes down. Conversely, when volatility falls, the Index value should rise. As you can see, volatility has exploded on the upside, and the stock markets have plunged to the downside. We have never seen a move of this magnitude, this fast before.
As the chart above shows, there is an extreme amount of fear in the markets today — even greater than in the financial crisis of 2008-09. As a result, markets are not functioning properly. This is why the Fed is taking repeated unprecedented actions in an effort to restore order.
It is just this kind of environment when algorithmic trading can accelerate. Another factor which can accelerate algo trading is when the odds of a recession suddenly increase, as we’ve seen over the last month. As this is written, there is widespread expectation that we’re headed into a recession.
The non-stop daily announcements of business closures, event cancellations, travel restrictions, etc., etc. – and now widespread fears of corporate bankruptcies – along with repeated warnings to avoid large groups and practice social distancing, have made this the “perfect storm” for stocks.
No one knows when or where this will end, but I have to think with stocks so severely oversold now, we should be near a bottom. Let’s hope so!
Finally, I am pleased to report that as of March 18, our Alpha Advantage Strategy has not only weathered this storm so far but has actually made money this year. We usually don’t report mid-month performance, but the strategy is up double digits so far in March and is profitable for the year. We will continue to monitor it and report to our readers the progress. As always, past performance is no guarantee of future results.
You may recall that Alpha Advantage features three professional money managers who can invest long or short (or in cash) in a single account. Given this chaotic market environment and the fact that Alpha Advantage has been profitable this year so far, I highly recommend you take a look at its impressive FACT SHEET. Be sure to read the Important Notes before investing and call us with any questions.
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