How Algo Trading Is Worsening Stock Market Routs

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How Algo Trading Is Worsening Stock Market Routs

Computerized, self-driving cars are being heralded as a significant step forward in highway safety. On contrast, in the stock market, automated trading algorithms are being accused of reckless high-speed investment, which is compounding recent price drops and bursts of volatility.

“Rules-based methods will remove emotion from it so that when selling occurs, more selling can occur and when purchasing occurs, more buying may occur,” Todd Rosenbluth, director of ETF and mutual fund research at CFRA, told Barron’s.

The S&P 500 Index (SPX) was up 0.81% from Thursday’s finish at the outset on Friday. This advantage has grown modestly to 0.85% as of 10:15 AM New York time.

‘Herd Behavior On Steroids’

As Rosenbluth said, algorithmic trading, also known as program trading, may generate self-reinforcing trends that develop at breakneck speed, well beyond the capabilities of human investors and traders to keep up and take evasive action. In fact, some programs are specifically built to follow trends, and the recent drop in stock prices was exacerbated when these algorithms abruptly switched from purchasing to selling.

In comments to Barron’s, Keith Lerner, chief market strategist at SunTrust Private Wealth Management, said, “It’s simply not usual, this activity [was] like a rubber-band snapped.” Momentum investing, in which investors sought for the hottest companies, contributed to the market’s quick growth. The reverse effect may now be at work, with selling demands increasing.

“The market is just as irrational and disconnected from fundamentals on the way up as it is on the way down. It is the nature of the markets now more than ever, thanks to Wall Street’s automated high-frequency trading tactics. This week has seen herd mentality taken to new heights “According to Washington Post business and economics writer Steven Pearlstein.

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‘Poisonous Feedback Loop’

Indeed, the issue is exacerbated by the fact that many of the financial businesses that develop trading programs and algorithms adhere to similar, if not identical, decision criteria. The Black Monday decline of 22.6% in the Dow Jones Industrial Average (DJIA) in 1987 was the consequence of a “poisonous feedback loop” among these systems, as explained in an earlier Barron’s article.

Trading algorithms have grown more prevalent in the years thereafter, controlling a growing proportion of overall transactions and thereby raising the risks. (For more, read Could Algo Trading Cause a Worse Crash Than 1987?)

Bots Rule

According to Business Wire, a recent research found that approximately $8.8 trillion of financial assets globally were managed by trading algorithms in 2016, and that this number is expected to expand at an average yearly pace of 8.7%, reaching $18.2 trillion by 2025.

Meanwhile, according to Bloomberg, figures from JPMorgan Chase & Co. show that quantitative and passive investment methods account for nearly 60% of all equity assets, a number that has almost quadrupled in 10 years. In comparison, the same statistics showed that human individual investors and discretionary investment managers currently account for just approximately 10% of equities trading activity. Index funds, whether organized as conventional mutual funds or ETFs, are examples of passive strategies.

Opposing View

Defenders of automated trading systems claim to numerous significant benefits, including consistency, discipline, emotion reduction, and analytical rigor. They claim that such systems add rationale to the trading and investment processes. Furthermore, proponents of high-speed trading find economic rationality in market prices fast reacting to changing fundamentals or changing perceptions of fundamentals.

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In reaction to the 1987 experience, prominent trading venues such as the New York Stock Exchange (NYSE) have installed circuit breakers or trade limits, which temporarily suspend trading in the middle of a rapid selloff. The goal is to calm down market participants and allow them to take a breather. (For further information, read The Advantages And Disadvantages Of Automated Trading Systems.)

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