As markets slowly return to something resembling normalcy, it’s important to maintain a sense of perspective about what has caused, and continues to cause, much of that nerve-wracking volatility.
So, while it’s certainly true that the impact of COVID-19 was decisive in wiping (temporarily) trillions in market value from U.S. stocks alone, there’s something else affecting the market to an extent that is still not completely understood: algorithmic trading.
A recent article in Investor’s Business Daily1 explained that: “Big banks, hedge funds and institutional investors use computer-driven trading algorithms routinely in bull or bear markets. (…) Algorithmic trading can escalate and worsen a stock market sell-off when triggered by news events or financial rules.”
Algorithmic trading explained
Algorithmic trading is a process for executing orders utilizing pre-programmed trading instructions to account for variables such as price, timing and volume. Computer algorithms send small portions of the full order to the market over time.
Algorithmic trading makes use of complex formulas, combined with mathematical models and limited human oversight, to make decisions to buy or sell securities.
- Around 80% of the daily moves in U.S. stocks are machine-led. Those machines are causing sharp drops and rallies based on immediate data releases.
- So-called high-frequency traders use algorithmic trading to move in and out of stocks at superfast speeds using powerful computers.
- Meanwhile, Wall Street firms hire quants, or mathematicians, to create algorithms for automated trading purposes.
A roller coaster ride
Amid the global spread of COVID-19, stock markets plunged in March 2020. An article in Fortune3 published that same month, summed up the situation succinctly:
“The stock market has had one of its most tumultuous months on record, with the S&P 500, Dow and Nasdaq all soaring to new highs in mid-February only to crash to within a whisker of bear territory on Monday.
Market watchers once again are casting a suspicious eye on the role of high frequency algorithmic trading in exacerbating the slide. Algorithmic trading, where a computer automatically executes trades based on pre-programmed instructions, has been around for a long time and is now a big factor in the daily ups and downs of the stock market.”
The virus outbreak turned global markets into the ultimate Disney World roller coaster ride, precipitating panic trading creating huge price swings. Stated a New York Stock Exchange floor trader, Matt Aronowitz4:
“When market volatility increases, liquidity decreases as market makers reduce the inventory they are allowed to carry within their portfolio.”
Those movements create escalating price moves, and higher frequency of algorithmic responses, becoming “a vicious cycle, which is why we have had such a drastic increase in volatility in such a short time period,” he went on to explain.
Mr. Aronowitz believes that the current volatility will ultimately lead to institutional investors putting money back to work and supporting the market. The current cycle of volatility will lead to a cycle of calm and market normalcy.
Keeping a long-term perspective
Most national governments, including our own, are stimulating their economies to sustain consumer demand, reduce business uncertainty and support the private sector in generating jobs. That’s helpful in reducing volatility, but it also means borrowing.
Right now, sizeable borrowing is necessary – especially since interest rates are close to zero. Even with the current level of borrowing, only a limited share of annual tax revenues would need to be spent on servicing the debt each year.
When borrowing costs remain low, a high level of government debt remains affordable.
Regarding the financial markets, one thing is sure, algorithmic trading or not, volatility is natural to stock markets and we must learn to live with it.