As investors revel in the exhilaration of one market high after another, the unsettling fact is that equities may endure a quicker and more devastating breakdown than during the 1987 crash. According to Barron’s, the rise of computer-driven algorithmic trading, often known as algo trading, has exacerbated that danger. A growing amount of money is being entrusted to rules-based systems known as algorithms to choose equities, make trades, minimize risk, wager on volatility, and do a variety of other things. Meanwhile, investors with long memories will remember that computer-driven program trading was a major cause of the 1987 crash, although such automated tactics played a considerably lesser role at the time. (For further information, read The Advantages and Disadvantages of Automated Trading Systems.)
Big and Fragile
According to statistics from Hedge Fund Research Inc. (HFR) provided by Barron’s, computer-driven quantitative trading techniques handled $933 billion in hedge fund assets in the second quarter, an increase of 87% from $499 billion in 2007. According to Barron’s, rules-based, computer-driven index ETFs account for nearly additional $3 trillion in assets.
Meanwhile, there have been many recent occurrences involving large, unexpected decreases in stock values. Barron’s cautions that the next major selloff might be exacerbated by fast-acting computers, which are playing an increasingly crucial role in the markets. “The system is more unstable than people realize,” says Michael Shaoul, Ph.D., chair and CEO of Marketfield Asset Management LLC in New York.
The Dow Jones Industrial Average (DJIA) plummeted 508 points, or 22.6%, on Black Monday, October 19, 1987. On May 6, 2010, the Dow lost almost 9% and the S&P 500 dropped approximately 7% in mere minutes of trade in mid-afternoon, before recovering. A similar situation happened on August 24, 2015, when the S&P 500 dropped 5% in the first few minutes of trading. According to CNBC, the Dow lost 1,100 points, or 6.7%, in the first five minutes of trade that day. (For further information, read The Two Biggest Flash Crashes of 2015.)
In 1987, program trading caused a “poisonous feedback loop,” as described by Barron’s, with computer-driven sell orders driving down prices, which encouraged even more selling by these programs. According to Barron’s, both the August 2007 selloff in quantitative funds that sent the S&P 500 down by 3.3%, dubbed as the “Quant Quake,” and the August 2015 flash collapse seem to have been driven by similar feedback loops in automated trading.
Very intelligent individuals can create significantly incorrect trading algorithms or rules-based quantitative funds. Long-Term Capital Management LP (LTCM) was a quantitative hedge fund with two Nobel laureates among its partners. According to Barron’s, the failure of its high-risk, highly leveraged trading approach in 1998 almost brought down the larger market until the Federal Reserve arranged a rescue.
While computer trading was a significant cause of the 1987 crisis, the overwhelming majority of deals were conducted via a sluggish, glacial-like procedure that frequently involved many phone calls and human contacts. With the rising computerization of the markets, particularly the introduction of high-frequency trading (HFT), deals are often performed in milliseconds. With the computers’ extraordinarily fast feedback loops, the selling pressure may quickly develop into a tidal wave, wiping away fortunes. Buckle your seatbelts.
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