Home Guides & Resources chevron_right Economy and the Markets The Rise of Algorithms: How Machines Move Markets Published February 22, 2022 Josh JurbalaQuantitative Investments Manager This week’s reader question: What is algorithmic trading and is it causing the volatilityA measure of how large the changes in an asset’s price are. The more volatile an asset, the more likely that its price will experience sharp rises and steep drops over time. The more volatile an asset is, the riskier it is to invest in. we’re seeing today in the stockA financial instrument giving the holder a proportion of the ownership and earnings of a company. 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. Algorithmic and high-frequency trading “grease the wheels” and improve market liquidityThe ease with which an asset can be bought or sold. Assets for which there are many buyers and sellers at any given time are highly liquid (for example, a stock which trades on a public exchange). Assets which trade rarely are illiquid (for example, a Picasso painting or a high-end home). 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 marketsA period during which stock prices rise significantly from recent lows for weeks, months or years.. The main riskThe probability that an investment will decline in value in the short term, along with the magnitude of that decline. Stocks are often considered riskier than bonds because they have a higher probability of losing money, and they tend to lose more than bonds when they do decline. 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 stocksA financial instrument giving the holder a proportion of the ownership and earnings of a company. 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 toleranceThe amount of loss an investor is willing to absorb in their investment portfolio. in mind, so there should be little need to trade intraday, and minimal chance for your portfolio to get derailed by fleeting volatility. Ask Us a Question! We’re always interested in the topics or concerns you might like us to comment on. Ask us a question about investing, the markets or financial planning and one of Adviser Investments’ experts will answer it in a future edition of The Week in Review. CLICK HERE NOW TO POSE YOUR QUERY. About Adviser Investments Adviser is a full-service wealth management firm, offering investment management, financial and tax planning, managed individual bond portfolios, and 401(k) advisory services. 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