The Algos Get Emotional

Tariffs, tweets and the breakdown in trade negotiations surprised investors over the last several trading days, pushing volatility to its highest level since January. While most market participants are willing to sit tight and let the news flow play out, algorithmic traders are not as patient.

The risk parity strategies used by algorithmic traders key off market volatility, dynamically adjusting allocations between stocks, bonds and commodities to maintain a target portfolio volatility. That means these strategies must sell equities as the VIX (CBOE Volatility Index) spikes and buy equities as the VIX ebbs. This also suggests that volatility begets outsized selling.

The Black Monday plunge on October 19, 1987 is forever etched in my mind. As a young trader, I felt helpless as the S&P 500 skidded more than 20 per cent that day, sparked in part by a strengthening dollar, but fueled by an 80’s algorithm called “portfolio insurance,” a popular strategy that sold shares as prices declined. Portfolio insurance programs chased their tails that day until they were shut down or unwound. The market subsequently recovered the next day and gained a little more than 10% over the rest of the year.

It should be noted that algorithmic trading today accounts for roughly 80 per cent of total trading volume, most of which is trend following. That’s one of the biggest reasons why the S&P plunges as volatility spikes, and explains why these downward moves tend to be exaggerated by electronic tail-chasing. As humans we shouldn’t let a sudden market move influence our emotions. Ironically, we let the machines get carried away.