High-Frequency TradingSubmitted by Destination Wealth Management on March 2nd, 2018
It’s not a surprise that markets continue to be volatile. While economic and corporate news certainly does influence swings in market values, below the surface another more potent force is at work causing significant fluctuations in trading assets.
What causes market volatility to be so severe, particularly in short periods of time, is algorithm-based trading that is executed by the latest generation of supercomputers. If you see the market move violently in a short period of time, it is likely not individuals or traders moving markets to such a degree. It’s likely automatic trading programs that trigger significant movement in market assets.
The algorithms used in a high-frequency trading do not solely focus on economic and corporate data, but nuanced inputs including the tone of language used by Federal Reserve officials in speeches and testimony are factored in. Any adjective that suggests the economy may be overheating may very well be an input to drive market volatility. Likewise, any perceived soothing words from Fed officials that the economy is not overheating can ease concerns resulting in a different action based on programmed algorithms.
Short-term volatility can lead to opportunities for entry and exit points in held or contemplated positions. High-frequency trading tends to react strongly to minor changes in economic news or data and this can create a cascade of market momentum. The fluctuation pattern can provide opportunities for fundamental long-term investors. Volatility, while disturbing, can be an opportunity to make adjustments in a portfolio strategy.
I am often asked what the impact of artificial intelligence will be on the economy. The obvious answer is there will be a significant impact everywhere we look. The most obvious example is driverless cars. But one should not overlook that artificial intelligence hardwired into computer programming (executed by warehouses of high-speed computers) will certainly impact our world and investors.
It’s a simple truth that someone out there will always have a faster computer. For that reason, attempting to play the short game in investment strategy is likely a losing proposition. The impact of high-frequency trading on investors, both institutional and individual, is that time horizon becomes an even more important consideration when making investment decisions.
Fundamental investment strategy tends to focus on valuation and the pricing of assets relative to future earnings or cash flows. Understanding that this is the foundation of a reasonable long-term investment strategy helps filter out some of the noise that occurs on a short-term basis. Computerized trading is a significant noise factor. The impact can be limited if one constructs an appropriate long term, diversified strategy.
The next time you see the markets rise and fall 300 points in one hour and then reverse course, remember it is likely not investors writing up trade tickets. Instead, volatility is likely triggered by high-speed computers over reacting on a moment’s notice to whatever inputs the program is designed to monitor.
If you have any questions about this information, please let me know. Hope you’re having a great week!