Market Volatility and Algorithm Trading

Artificial intelligence is no longer a futuristic concept that we see unfolding only in movies. It’s real, and it’s affecting our everyday lives today — it even causes fluctuations in the stock market.

The year 2018 saw some larger swings for the broader equity indexes in the United States. In fact, 5 of the 10 biggest single-day gains and declines for the Dow Jones Industrial Average happened in 2018. While the intra-year lows were in line with historic norms, the day-to-day swings were much broader. The question is, why?

Algo Trading vs. Program Trading

One of the factors contributing to much of the volatility is the use of algorithms and computers in trading, sometimes called “algo trading.” This term refers to market transactions that use advanced mathematical models to make high-speed trading decisions. Many analysts believe that the various sell-off episodes seen throughout 2018 were caused by these machines because they act on immediate data releases without taking the time to digest them, as humans would.

This is different than program trading. The New York Stock Exchange defines program trading as any trade involving 15 or more stocks with an aggregate value in excess of $1 million. Rudimentary program trading began in the seventies, but with a person making the decisions. Today, computers use artificial intelligence and algorithms to trade independently.

“Eighty percent of daily volume in the U.S. is done by machines, so what you get is a lack of focus on earnings, a lack of focus on outlooks, and you just get short-term movements based on very specific data that is released every day, and that creates noise,” Guy De Blonay, fund manager at Jupiter Asset Management, told CNBC’s Squawk Box Europe. In fact, on some days, this program trading can account for as much as 90 percent of the volume. As the market moves up or down, programs may look at the momentum and simply sell or buy. That can exponentially increase the volatility without any basis in fundamentals.

Art Hogan, chief market strategist for B. Riley FBR, stated, “A machine is making a decision based on the fact that we reached a level to buy or sell. The problem with that is everyone’s algorithms are pretty much the same; they key on the same trigger points. That causes really fast momentum swings.”

This is not like in The Terminator, when Skynet takes over the world. (In case you’re not an Arnold Schwarzenegger fan and/or haven’t watched the Terminator movies, Skynet is a fictional artificial neural network-based conscious group mind and artificial general intelligence system that serves as the main antagonist, or character, in the movies.) With algo trading, there is some human oversight; however, the independent automated trading is a much bigger part of daily movement than people might be aware of.

What to Do when the Market Fluctuates

Now that we understand a primary reason why the market swings were so broad in 2018, then the next question is, what should we do?

The simple answer is that if your portfolio is allocated properly based on your personal needs, objectives, risk tolerance and tax situation, then you can ignore the short term. You do not need to do anything. We design portfolios with volatility in mind — regardless of the source or cause. We strongly recommend that you make changes to your portfolio based on your changing needs and vision — not on day-to-day or month-to-month market movement.

We are happy to discuss your personal vision and review your overall investment planning without cost or obligation. Feel free to contact me personally, or anyone on our team. We look forward to assisting you. Randy Carver – or (440) 974-0808

The information contained in this blog does not purport to be a complete description of the securities, markets, tax rules or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of Randy Carver and not necessarily those of Raymond James. Expressions of opinion are as of this date and are subject to change without notice. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct. Investing involves risk, and you may incur a profit or loss regardless of strategy selected. Raymond James and its advisors do not offer tax or legal advice. You should discuss any tax or legal matters with the appropriate professional.