12:34 PM
Global Market Volatility Comes as No Surprise
Most conversations about the financial markets last week centered largely on the "extreme" market activity taking place. "Experts" everywhere were completely surprised, suggesting the market behavior was caused by everything from credit downgrades to aliens (well, almost). We at Woodbine Associates are amazed that so many savvy market professionals and observers have been so taken aback by this activity; we are also unimpressed by the widely divergent range of explanations and analysis, most of which miss the point.
We have said it before and shall say it again: the current market activity is an expected, short-term aspect of the market structure we have created through regulation and technology.
We have seen last week's global market rollercoaster before. The good news is it follows a clearly discernible pattern of event types observed on May 6, 2010 and during other recent periods of significant directional movement and volatility.
How These Seemingly "Extreme" Periods Are Triggered In US Equity Markets:
- One or more significant, fundamental, economic event triggers a large scale buy-sell imbalance among instruments in one market.
- The buy-sell imbalance pushes prices downward.
- Market mechanics kick in:
- Liquidity takers begin to "walk the book." Stop-limit orders execute. Orders with limits away from the prevailing quote under normal conditions are triggered. Algorithms kick in, amplifying the directional movement.
- The security becomes over-sold. At some point, short-covering begins. More algorithms are triggered. High frequency strategies designed to identify mis-pricing are initiated. These activities stem, and eventually reverse, the market directional movement.
- The direction of price movement is reversed. However, momentum largely created by automated trading activities pushes price past fair value in the opposite direction, toward the upside, until an overbought condition is created. Similar activities that reversed the precipitous fall in prices reverse the upward movement in prices.
- The cycle continues, amplified by fear, uncertainty, and retail investment flows. It spreads across markets and geographies, where that fear, uncertainty, and speculation may cause unexpected movements in those markets. This, in turn, can perpetuate or amplify the activity in other markets.
This chain of events should not surprise anyone. It is the "price" we pay for tighter spreads, lower latency, better executions, more liquidity, and lower volatility during "normal" market periods.
Let's look closer at what happened last week.
Matt Samelson is a Principal at Woodbine Associates, Inc. focusing on strategic, business, regulatory, market structure and technology issues that impact firms active in and supporting the global equity markets. He brings to the firm a wealth of experience in U.S. and ... View Full Bio