THERE’S NO SUBJECT that gets me more worked up than market volatility—and especially the danger posed by high-frequency trading (HFT). Volatility has become part of the “new normal,” thanks to fundamental changes in how the market operates.
Remember the flash crash of 2010? I haven’t forgotten the unsettling events of May 6, 2010, when the Dow Jones Industrial Average dropped 600 points in just five minutes. For a few minutes, starting around 2:45 p.m., prices entered an alternative universe that few could comprehend. One Dow Jones stalwart, Procter & Gamble, reached $100,000 a share, while otherwise strong companies such as Boston Beer and Accenture saw their stock temporarily drop to a mere one cent per share.
There was an equally fast recovery but, in my opinion, the damage to institutional credibility had already been done. The 2010 flash crash was one of the mileposts that reminds us that we live in a brave new world. The events of that day, which could have been far more catastrophic, were not the result of a so-called rogue trader or an accidental push of a button, but something more systematic.
It was a snapshot of what happens when the human side of order execution is superseded and overwhelmed by sophisticated computer algorithms. These algorithms can automatically kick into action across the market, some designed to protect existing investment positions, while others ruthlessly exploit mis-pricings. Many times, they’re designed for quick buys, sells and profits. When algorithms are involved, the profits or losses are made in nanoseconds.
It’s easy for many to regard the 2010 flash crash as an anomaly, but my 28 years as a financial advisor tells me that isn’t the case. Markets are analogous to oceans with species that make up a complex and interdependent ecosystem. When one of those species, algorithmic trading, becomes 70% of the ecosystem, the imbalance can potentially undermine the system’s overall health.
Normally, few would argue against increased liquidity—the ability, at any given moment, to find someone to take the other side of your trade. But the current environment is hardly ideal, because more liquidity than ever is based on HFT. One second, the price that’s being bid for a stock is good. The next second, the bid is gone. In my opinion, the HFT tail could be wagging the stock market dog. For shareholders and the overall economy, this is a sobering reality.
If we “enjoy” another flash crash, the psychological impact on investors could be significant. Never before have we seen such a dichotomy: Some investors, such as pension plans, endowments and 401(k) investors, are aiming for long-term returns, while others are eyeing micro-second chances to score a short-term profit.
When I began as a financial advisor almost three decades ago, the New York Stock Exchange had a specialist system whose job was to “provide a fair and orderly market.” Today, thanks to computerized algorithmic trading, anything goes. What does that mean for everyday investors? If you are indeed a long-term investor, there’s a good chance you’ll be tested in the short term—and it’s crucial to stand your ground when algorithmic trading next makes the markets seem temporarily insane.
Tom Sedoric is executive managing director of the Sedoric Group, a financial advisory firm in Portsmouth, New Hampshire. A Wisconsin native, he loves being on the water, knows some amazing card tricks and can fix just about anything.