Don't blame the robot traders for stock market volatility

​"Institutional investors didn't see this coming – and they are trying to find excuses," says Associate Professor Elvira Sojli from UNSW Business School. "High Frequency Trading isn't to blame – it's risk management mixed with investors reallocating resources across markets."

US share indexes have rebounded from the biggest one-day drop in more than six years after a frantic trading session, even though European markets closed in the red again on Tuesday. The stock market sell-off started last week when US employment numbers showed strong employment and wage growth, which could push inflation and lead to interest rate increases. Much attention has been focused on high-frequency trading, where computers are programmed to trade stocks in microseconds.

However, Associate Professor Sojli says robot traders don't trade in a vacuum, and instead the cause of the chaos may be an investment and risk management strategy. "Bots are programmed to make trades that humans want, in a more systematic way. There was a market expectation that if yields – or interest rates - reached close to 3 per cent, there would be a switch out of equities towards bonds. Friday's job market report pushed bond priced down and yields up to 2.9 per cent, and at these point many algorithmic orders traded out of the equity market. The price decreases – or losses - triggered stop loss orders, which led to a huge sell off."

The Dow had a more than 1,100-point difference between its high and low points yesterday.

Associate Professor Sojli analyses swings in the stock market and suggests the current volatility and decrease in prices is a conflation of several effects, including the US employment numbers, along with recent US tax cuts, which both stimulate inflation and the need for an even higher debt, which will increase rates. "It might too much of good thing for the economy," she suggests. "In any case, there was a correction in sight, and all these contemporaneous other events have made it worse."

"From a pure finance model, when interest rates increase, the discount factor increases, and future cash flows have to be discounted more heavily and lead to revaluations of stock prices, or price decreases," she says. "This can be seen not only in the stock market but in the foreign exchange market as well, where the US dollar has regained a lot of the lost ground in the last two weeks. Higher interest rates create demand for that currency and fuel higher exchange rates."

Associate Professor Sojli has researched how higher interest rates fuel higher exchange rates, and how political uncertainty creates stock market volatility.

"In Australia we caught a cold yesterday when the US sneezed," she adds.

"It was well known that bots would sell heavily as soon as there were enough positive indicators– and that's exactly what happened. Today traders are catching up -  as investors try to cash in made gains, just in case the drop is not temporary – a pure behavioural effect."

For further details contact Elvira Sojli on e.sojli@unsw.edu.au or 02 9385 4900.

Media contact: Julian Lorkin: 02 9385 9887 | 0405 805 365 | j.lorkin@unsw.edu.au