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Trading Algorithms & the 2018 Sell-Offs
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Most of you know that the overall stock market has seen a lot of sell-offs in October, November and into December of 2018. Naturally, investors want to know what caused these sell-offs. The stock market on any given day is influenced by a number of variables. However, most agree that the sell-off was attributed to computer algorithms or computerized stock programs trading. What are stock trading algorithms anyway? Well, simply it is a process of using computers programmed to follow a defined set of instructions (algorithms) for placing a trade order at a speed and frequency faster than a human trader.
Over the past ten years algorithmic trading has grown in the U.S. by about 70% of overall trading volume. And it is not exclusive to just the U.S. either. Some estimate that on any given day these transactions account for 50% to 60% of the trades. During high volatility it increases up to 90% of the daily trades.
The computer algorithm or code is made up of specific variables that it looks at and then executes based on triggers. For example, one variable is the Federal Reserve’s move on interest rates, another variable is the difference between the 10 year and 2 year Treasury Bill interest rates. These two variables, in our example, provide input to the software code and the programmers have instructed the code to automatically sell-off stocks if these inputs hit those set triggers. At the onset it sounds very logical and safe, right? However, the problem is everyone is using the same set of parameters or variables in their code. So that when the triggers are hit everyone is selling off which drives the large volumes and thus the major point drops in the stock market. Thus you see 300, 400, 600 or 800 points drop in a single day of trading. For example on 10/10/18 the DJIA closed 831.83 points lower at 25,598.74 as shown by this CNBC chart here.
These machines don’t second guess themselves like human traders, or worry over the losses they create. They are emotionless and perform their job extremely well which is why they exist in the first place. The software programmers designed them for this very reason. Execute immediately when these variables hit a defined trigger, period.
As a result of these major sell-offs in the fourth quarter of 2018. Some are calling for the SEC to bring back the uptick rule. The uptick rule was created in 1938 and would have prevented the recent deep decline. But the SEC eliminated it in 2008. The uptick rule was a trading restriction that stated that short selling a stock is only allowed on an uptick. Short sales were not permitted on minus ticks or zero-minus ticks subject to narrow exceptions. It prevented short sellers from adding to the downward momentum of an asset already experiencing sharp declines. It is unclear whether the SEC will bring the rule back at this time.
These computers are focused solely on short-term trading only. As a human investor, you should look for opportunities created by these computers to buy stocks at lower prices caused by these sell-offs. These machines actions create volatility only in the short-term but have little influence over the long-term horizon. This is another reason why taking the long-term strategy is always better as it smooth outs these types of short-term events or low points.
We understand taking the long-term strategy is the better path to above average gains and thus we focus on investments over that time frame. We see short-term volatility as an opportunity from Mr. Market to buy at lower discounted prices that before. So do not “follow the crowd” and sell your investments at this point. Instead now is the time to buy new positions or add to existing positions as prices are discounted even more.
At Port Wren Capital, LLC, we specialize in picking specific undervalued U.S. stocks using fundamental analysis developed by Benjamin Graham using a five step process. We have beaten the S&P500, DJIA and NASDAQ benchmarks since we started 5 years ago on our own investments. Discover the difference for yourself. To learn more contact us today.
Published: 1/1/19
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