How automated trading riles stock volatility
Joel Dresang: Paige, stock market volatility can be very frustrating for long-term investors. One of the forces behind those swift swings in stock prices is automated trading. Can you explain a little what that is?
Paige Radke: In the most basic of terms, it’s investing on autopilot. So automated trading is a strategy primarily implemented by ETFs, Exchange Traded Funds, and some more complex products like hedge funds, where the traders set a particular set of rules for buying and selling, and those are then automatically carried out by computers.
Joel: So how does automated trading affect volatility?
Paige: We’ve seen the impact of automated trading primarily in downturns. Since computers are the ones executing the trades, they can react instantly to technical indicators like price movements.
So, as prices start to go down, ETFs automatically rebalance and sell instructions are triggered, which causes things to sell more, and the sell-off becomes more pronounced. It essentially becomes a self-fulfilling prophecy.
Joel: So it sounds like automated trading is very short-term market timing, based as you said, on technical indicators, and not on fundamentals like corporate earnings and interest rates and valuations.
Paige: Exactly. So automated trading tends to look more at momentum, or the extent of price movements, rather than the underlying value of a company.
While the market is generally efficient, by taking people out of the process, we’ve seen an increase in that volatility, which has led to an increase in mispricing of the underlying securities, especially in the short term.
Joel: Paige, what are the consequences of automated trading for long-term investors who want to stick to those fundamentals?
Paige: The number one thing that investors need to remember is that the rise in automated trading has led to the increase in the potential for larger swings in the market. So what we’ve seen is basically an extreme case of trend is your friend, where for long-term investors, the trend is no longer your friend.
That said, it’s not all bad. One of the positives from automated trading is it’s led to an increase in liquidity. So, as these computer trading platforms compete for the best prices and trying to get to those prices first, we’ve found that it’s easier to match buyers with sellers, which is a net positive for long-term investors.
Joel: What can long-term investors do about automated trading?
Paige: The number one thing that they need to do is recognize what’s going on. So, if that volatility is increasing but there’s no changes in the underlying fundamentals and no changes in the economy long-term, there’s a good chance that it’s going to be short-lived. Remember, volatility is only bad if it scares you into trying to time the market and selling at the wrong time.
What long-term investors should do is trust in their asset allocation and keep their portfolio – and their head – in the game when things start to get a little bumpy.
Joel Dresang is vice president-communications at Landaas & Company.
Volatility: What to watch for and why, a Money Talk Video with Kyle Tetting
Focus on fundamentals to face volatility, a Money Talk Video with Steve Giles
Volatility: Stock market vs. your portfolio, a Money Talk Video with Kyle Tetting
Risk: How much can you stand? How much do you need? a Money Talk Video with Isabelle Wiemero
The ups and downs of volatility, a Money Talk Video with Steve Giles
Your one-minute guide to stock volatility, from the Financial Industry Regulatory Authority
(initially posted January 29, 2019)
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