The Rise of Algorithms: How Machines Move Markets

The Rise of Algorithms: How Machines Move Markets

February 22, 2022

This week’s reader question: What is algorithmic trading and is it causing the volatility we’re seeing today in the stock market?

Quantitative Investments Manager Josh Jurbala had this to say:

Great question on a very relevant topic.

First, let me explain what we mean by algorithmic trading: An algorithm is a rules-based process for performing a task, typically involving mathematics and computer-based calculations. In financial markets, “algos” execute complex calculations at a faster speed and with less human error and behavioral bias than people can achieve on their own.

In the case of trading, algorithms can be used to automate decisions and change portfolio allocations according to sets of rules. The subset of algorithmic trading most prevalent in today’s markets is called high-frequency trading (HFT). HFT firms use algorithms (along with powerful computers and extremely fast internet connections) to identify trade opportunities and execute large orders at lightning-fast speeds.

Photo of quantitative investmnets manager Josh Jurbala and a quote stating "Long-term investors, like our clients, should not be concerned by the rise of machines in day-to-day trading. We’re very careful to make sure your portfolio is properly positioned with your personal goals and risk tolerance in mind.”

Algorithmic and high-frequency trading “grease the wheels” and improve market liquidity and price discovery. This makes it easier for buyers and sellers to transact at consistent prices, which can lower overall trading costs for retail traders and low-frequency trading investors like us. The increased volume from electronic trading can also dampen volatility and benefit stock performance, especially during positive-trending bull markets.

The main risk of HFT—which by some estimates accounts for 50% of stock trading volume—is that automated trading can also exacerbate volatility, particularly during a crisis or sudden market sell-off. This phenomenon was brought to light during the famous “flash crash” on May 6, 2010, when stocks suddenly plummeted in a matter of minutes, before recovering nearly as fast that same day.

At Adviser Investments, our tactical strategies (subadvised by our Adviser Capital division) use algorithms to measure price momentum and determine trades, regularly adjusting portfolio allocations to manage risk and follow market trends. But unlike the strategies discussed above, our client portfolios trade less frequently (over days and weeks) and in lower volume with minimal market impact. In other words, we use algorithms as a short-term means to achieve long-term investment objectives.

Long-term investors, like our clients, should not be concerned by the rise of machines in day-to-day trading. We’re very careful to make sure your portfolio is properly positioned with your personal goals and risk tolerance in mind, so there should be little need to trade intraday, and minimal chance for your portfolio to get derailed by fleeting volatility.

 

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