Big banks, hedge funds and institutional investors use computer-driven trading algorithms routinely in bull or bear markets. When the stock market turns volatile, algorithmic trading often gets the blame.
Algo trading can escalate and worsen a stock market sell-off when triggered by news events or financial rules.
Amid the global spread of the deadly coronavirus, stock markets plunged in March, triggering circuit breakers that halted marketwide trading several times.
On the other hand, one view is that algo trading in normal volume has been a factor in the market’s rebound off the March lows.
The internal trading desks of brokerages, hedge funds and institutional investors use computer-driven trading algorithms routinely. Trend-following algorithms may kick in, for example, when stocks fall below their 200-day line.
Simply put, algorithms are complex math equations used to program computers to make decisions. They come into use in a number of industries.
On Wall Street, traders employ algo trading to buy and sell stocks automatically. Algorithmic trading may extend momentum trades as stocks make a big run.
How HFT Traders, Quants Use Algo Trading
So-called “high-frequency traders” use algorithmic trading to move in and out of stocks at superfast speeds using powerful computers and robust internet connections.
Meanwhile, Wall Street firms hire “quants,” or mathematicians, to create algorithms for automated trading purposes.
In routine trading, traders may use preset criteria to execute orders. For example, algo trading could use preprogrammed rules for when a stock reaches or falls below a 50-day or 200-day moving average.
A 2014 study claimed that one positive impact of algorithmic trading is that it made stock markets more liquid and efficient.
In addition, algo trading can hide the identity of large buyers and sellers. Some brokerages use algorithmic trading to split up orders so the size of their trades will not be observable.
Individual investors, also called retail investors, aren’t users of algorithmic trading tools. While there have been a few attempts to make algo trading software available to individual investors, they didn’t work out. And, the trading volume and costs associated with algorithmic trading make it impractical for retail investors.
Individual investors, however, can turn to investing tools such as IBD’s CAN-SLIM.
Does Algorithmic Trading Worsen Stock Market Volatility?
Many link algorithmic trading with stock market volatility and triggering sell orders. One example: the “flash crash” of May 2010, which wiped $860 billion from U.S. stock markets in less than 30 minutes.
Algorithmic trading may kick in when there’s a jump in the VIX index, a measure of anticipated market volatility. In addition, algo trading may initiate when odds of future market losses increase.
Preset sell orders also engage when odds of a recession suddenly increase. One sign of a recession, for example, has been an inverted yield curve.
In April 2019, Bitcoin suddenly jumped 20%. Some observers speculated algo trading might be behind the sudden move in the world’s most popular cryptocurrency.
Aside from stocks, traders now use algo trading more often for traditional currencies as well.
Follow Reinhardt Krause on Twitter @reinhardtk_tech for updates on 5G wireless, artificial intelligence, cybersecurity and cloud computing.
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