When it comes to share prices, one thing that has always bothered me is how influential one trade can be on the market.
I mean – we assume that the market is efficient enough that the last traded price is the “value” of the share in question. But that is all kinds of problematic.
Example: if I have thousands of shares in a company to sell, and I have to liquidate in a hurry, I can take those shares to the market, sell at a discounted price in order to close out the trade ASAP, and move the entire market. The price that I accept will be the price that the market registers as the current value of the share.
At this point, I’ve changed the value of a number of important stock indexes: the overall market index, the industry-specific market index, and to a greater or lesser degree, every index that has that particular company or industry or stock market in its underlying composition.
But that now has repercussions. If you’re in the US, ±27% of all equity investments are tied up in index-tracking funds. So now those funds will have to re-balance their underlying investments in order to take into account the revised indexes that I just affected. This will result in some selling of shares. Which will affect the price. Which will affect the index. Which will affect the re-balancing until the price changes are small enough to fall within the acceptable limits of tracking error. #loops
Into this mix, now add algorithmic traders, who are busily watching the markets for statistical arbitrage and technical-signs-of-momentum. Some algorithms will see my trade, and interpret it as a potential sell-off starting, and starting selling-off. Other algorithms might see the trades of the momentum algorithms, and see it as a chance to engage in some statistical arbitrage by going short on the exchange-traded funds that are linked to the index whose values will drop come rebalancing time. Which will affect the index-tracker funds even more.
Multiply that ad hysterium.
I realise that I’m applying the “butterfly-wing→hurricane” scenario here – and in practice, my trades are going to be offset by other trades that are happening at the same time.
However, these are ebbs and flows. And I think that we sometimes underestimate the potential feedback loops that the current trading environment is capable of generating.
Specifically, I feel this lingering disquiet around the interplay of high-speed algorithmic trading volumes, and growing investments in passive index-tracker funds. Because: half the market trades take place on autopilot, while a quarter of the funds are voluntarily blind.
Anyway. That aside, here are related-things to be aware of:
“Some firms allow algorithm programs to learn and create their own rules. However, the firms are unaware of the rules the programs create.”
But don’t worry, markets are efficient.
For more: last week Friday’s post.
Rolling Alpha posts opinions on finance, economics, and the corporate life in general. Follow me on Twitter @RollingAlpha, and on Facebook at www.facebook.com/rollingalpha.
Kosta September 2, 2015 at 10:36
If markets reached a stage of perfect efficiency, what would be the outcome?
If this was answered in Ecos 101, I blame old age.Reply
Jayson September 2, 2015 at 11:47
As in: perfectly unbiased, rational and virtually prescient efficiency?
Well, according to the Efficient Market Hypothesis folks, shares would always and everywhere be fairly valued (incorporating all material and non-material, public and non-public information), and you would not be able to earn “excess” returns. That is: you would only be able to earn returns that correspond to the level of risk that you take on.
But I think that, if you take this a step further, one might ask whether “perfect efficiency” implies no trade taking place at all…
If everything is fairly-valued, and takes into account both the company fundamentals AND the particular sentiments and liquidity needs of all traders, then the market price for a share would be set at a point where investors are ambivalent between owning and not-owning the share. And if you already own it, then there would be nothing to be gained by selling it – and if you don’t own it, then there would be nothing to be gained by buying it. And even if the price moved due to new information, that price would move before any trade took place. At which point, you’re back in the same position of ambivalence.
I mean, now I’m speculating. But everyone would be speculating at this point – we’re talking about hypothetical perfection, and none of us knows what that’s like!Reply