Although I am not frequently high as the title implies, market volatility and trading volume are, which can cause wild swings in stock prices within a short period of time. Equity price movement, be it small or large, happens all the time, so it’s your responsibility as a retail investor to ignore these short term volatile irrational price movements and focus on investing for the long term. Institutional investors are no different. These types of large entities and other publicly traded companies always have some sort of risk management in place to protect themselves from short term price movements, either in the form of shorts, forward or future contracts, or hedging strategies.
Sudden price swings are attributable to large volumes of shares being traded at a time, either by large financial institutions, public company insiders, high frequency trading instruments, other trading instruments, and outside influence from social media sources. What exactly constitutes as these “instruments”, and should you be concerned with how they can affect your overall portfolio?
High Frequency Trading
High frequency trading, or HFT, involves the creation of algorithms to execute an extremely large number of trade orders within an extremely small time frame. HFT takes advantage of speed to fill buy and sell orders to make small profits on tight bid and ask spreads. Although profits are small, thousands of these trades a day can provide a substantial return for an investor. HFT can be used to take advantage of arbitrage opportunities in option pricing, commodity trading, or any misalignment between equity pricing models and actual stock prices. HFT is also used simply to execute orders quickly in order to buy or sell at a given price before the price changes.
HFT is criticized as having the capability of making human trading decisions and triggering high volumes of buying and selling. While this does give more liquidity to the market, some may argue that high frequency trading happens so fast that any investor (retail or institutional) doesn’t even see it happening in the background. Level 2 trading screens show the bid and ask spread for any equity. HFT won’t even show because the orders are happening so quickly. Sure, HFT may drive the price of an equity in an exaggerated direction during times of extreme volatility, but as a retail investor, this should be irrelevant. Any responsible individual who is investing for the long term should be absent minded of, and shouldn’t really care about, the short term swings and movements of the market. Dollar cost averaging over the long term, whether it’s into the market or into well managed profitable companies who can consistently grow earnings, ignores such movements. Besides, markets are not, and never were, driven by retail investors. The trading volume of retail investors into the market on a daily basis is almost immaterial. Large financial institutions that manage multi billion dollar books can and will trade millions of shares every day. This may seem like a lot, but even exchange traded market volumes don’t compare with over the counter markets for bonds, which in 2018 was a >$60 trillion dollar industry. With all this said, sure HFT might be a pain in the rear for frequent day traders losing money daily on unpredictable market movements, but even without HFT, I would say day trading is not a responsible way of managing your capital. Investing decisions should be made with a long term strategy in mind, and based solely on company fundamentals rather than technicals and emotion. Never once since I started investing have I felt wronged or cheated because of HFT. Only I was to blame for my irrational investment decision making.
Another concept associated with HFT is called Spoofing. Spoofing occurs when traders attempt to give a false view of market conditions by executing a large volume of trading to influence the movement of a particular equity in a desired direction. It’s most commonly used to manipulate price movements in the commodity market. In other words, it’s a form of short-term market manipulation. As a retail investor, this shouldn’t matter at all or factor into one’s decision making when investing long term. Spoofing won’t drive markets or equities in a certain direction long term. This may exaggerate price movement very short term, but that’s it. I can technically do this in my own brokerage account for an illiquid stock that I own with very large bid-ask spreads. I could execute “buy at market” orders with small volume to drive the stock price up, therefore making the worth of my existing shares that I hold higher. There’s nothing wrong with this, and it’s not too hard to do with very illiquid stocks, but I perhaps will only be able to do this for a very short amount of time before either my own liquidity dries out, or the so called “arbitrage” goes away and the bid ask spread closes. For the majority of the market which is comprised of mid cap or larger companies, bid ask spreads are usually very tight, perhaps a cent or a fraction of a cent. For any investor, executing market orders on these types of equities is sufficient enough. Any occurrence of spoofing just happens in the background without you even noticing.
Lot size affects how “effective” HFT can be. Lot size is simply the number of shares put up for a trade order (buy or sell). Execution of orders with small lot sizes will see a more frequent movement in the stock price as it jumps between different order execution prices. However, bid or ask prices have to be fully filled (not partially) in order for the stock price to move beyond that bid or ask price. Small lot sizes just ensure orders are filled in between a narrow bid ask spread. Again, as this ties in with HFT, the concept of small lot sizes used to influence short term price movement should be irrelevant for any long-term investor.
As a retail investor, speed is never on your side. You execute a trade, then your brokerage firm sends your order to the relevant Clearing House, where your trade is documented and executed if the order is approved. Trading firms and other large institutions that trade high volumes on a daily basis actually invest a lot of money into the type of wires used to send electronic signals from their computers to the end user who receives the trade. Speed is really a moot point when it comes to executing limit orders, and executing a market order on a liquid stock will ensure a filled order within a cent or two of the current trading price anyway. Whether it’s half a cent, one cent or two, it shouldn’t alter your decision making as to whether you should be purchasing an investment for the long term. Bid ask spreads consisting of hundreds and thousands of shares daily ensures constant liquidity. Don’t worry, you will get your shares. If you’re too impatient, just do a market order if you don’t care what price you get filled in at.
HFT is also criticized for its ability to trigger open orders on the market in times of enhanced volatility, namely stop loss orders. Stop loss orders are simply prices at which an investor is willing to sell their shares at. Think of it as a threshold or risk appetite in terms of the minimum price an investor is willing to hold onto a stock for before dumping their shares. The criticism around HFT is that it can lead to wild price swings that can trigger a stop loss order, and sell an investor’s shares at a time when they may have not wanted to sell them yet. The use of a stop loss instrument will execute a sell order instantly when the underlying equity price meets the trigger price. Any retail investor can put stop loss orders in. However, if you don’t use stop loss orders, then this issue is irrelevant for you. Short term daily swings of a stock are to be expected, and one shouldn’t worry about this. This is why it is important to give enough room for volatility when setting stop loss orders.
Shorting
In addition to HFT, shorting and naked shorting can also impact the way equity prices move over a short period of time. Naked shorting essentially involves shorting a stock (borrowing a stock and selling it with the promise of buying back at hopefully a lower price) without actually borrowing the stock, or ensuring that it can be borrowed. First of all, naked shorting is illegal, but there are loopholes in which traders are still able to execute naked shorts in today’s market. Typically with shorting (the legal version), any brokerage firm/Clearing House that has to execute a short not only has to ensure that the investor has this feature enabled in their account, but has to ensure that he or she has sufficient margin (i.e. collateral in the form of cash and other equity holdings in the account) in their account to do this trade. To protect themselves against counterparty risk, the short position is marked to market every day, and margin requirements are checked daily. If the investor fails to meet the margin requirements, they will be asked by their brokerage firm to supply sufficient margin. If the investor fails to do so within 3 or so business days, the broker will automatically begin liquidating the investor’s current holdings in order to meet margin requirements. Shorting also requires the investor to make interest payments monthly (because you are essentially borrowing money), as well as pay out any dividends issued by the company they are shorting during that time. The criticism with shorting and naked shorting in influencing the direction of equity prices has to do with when short squeezes occur. Short squeezes can happen and will cause market upward pressure in times of extreme volatility, where investors who are short are “squeezed” out of their position when a stock is rising in price, and are forced to close (buy back the shares they are short) because their short positions are underwater and are forced to fill margin requirements. This increases the amount of buy volume for that particular stock, driving up the price even more. In the end, these will cause brief disruptions in the stock price, and will eventually regress back to normal trading levels once investors begin selling shares at the high prices once shorts have been squeezed out.
Social Media
Social media allows anyone with half a brain and an opinion to post anything about a company. This may cause a very brief disruption in a stock price and cause it to spiral downwards (or upwards), but this should all just be noise to a rational intelligent retail investor. If Kylie Jenner says “I don’t like Snapchat”, Snapchat shares will fall. Great… what a useless statement with nothing behind it. Assuming Snapchat is a great profitable business (which it’s not, but for arguments sake let’s assume it is), any smart investor will take advantage of irrational behavior and exploit the opportunity to buy Snapchat shares at very cheap valuations. Social media doesn’t drive equities long term, but company fundamentals and earnings do. If I based my investing decisions on anything I read on social media, I’d be bankrupt. I do believe social media can be a good platform for information on businesses from reputable professionals in the investing industry, especially finance industry experts who go against the grain of the most recent hype in the finance world. I have a lot of respect for certain high profile short sellers such as Andrew Left from Citron Research, and Marc Cohodes. Although I’ve been burned before on stocks that these guys have shorted, these are very intelligent people and know what they’re doing. Sure, they make money on the name they are shorting which tends to happen immediately following their social media post on what they are going to short, but almost always, these guys are right. The companies they are shorting are being shorted for a reason. Whether there’s accounting malpractices, revenue recognition issues, channel stuffing, misstatement of earnings, or other fraudulent behaviors or activities, these guys hit the nail on the head the majority of the time. It’s the reason why Concordia Health Care, Valeant, MiMedx, and Home Capital have all either gotten close to bankruptcy, or have been/are currently being investigated by the SEC (or the equivalent provincial legislative body here in Canada) for business malpractice and ripping off investors. These short sellers and market bears are some of the people I actually follow on social media because their full-time job is to poke holes where things stink, and their perspectives always bring me back down to earth as opposed to the puke inducing constant bullishness of overvalued hype nonsense like Tilray or Namaste, or any other non profitable pie in the sky cannabis company. I encourage you to follow some of these people on Twitter or other social media platforms to get an unbiased opinion on markets, and a sense of reality. As an investor, you base your decisions on the fundamentals that are reported and audited by reputable accounting firms. If these statements are false, there’s no way of knowing that as a retail investor, and you can lose money when these criminal practices and wrongdoings are brought to light by short sellers and the stock you own tanks 50%. Retail investors should be concerned about remaining diversified in their portfolios and having open unbiased minds towards equities and markets as a whole, instead of looking at the forces behind unwarranted short-term market volatility.
Markets will always be unpredictable, and can show periods of heightened volatility. But in the long term, markets are biased to the upside, and as a individual investor, whether you are investing in market ETFs or individual companies, you should be looking long term, and focus on choosing well managed, fundamentally strong and profitable companies to invest in. Make this a highly frequent behavior instead of being frequently high and focused on forces beyond your control that can swing markets in an unwarranted direction short term. If anything, for the more active investor, it’s during these times that one can take advantage of over exaggerated price movements to buy a security for really cheap, or sell an equity at elevated prices. For long term investors, typically just doing nothing during these volatile times is the best course of action.