Whether it’s rising bond yields, sticky inflation, or geopolitical events pushing oil prices higher, the market’s reaction has been remarkably consistent.
First stocks dip briefly – but buyers soon emerge and send them higher again. Dips barely last more than a day. And even a 2% or 3% pullback has felt like a big move.
One of the major causes is the sheer volume of algorithmic trading. It’s changed the structure of the markets.
And if you aren’t careful, you can be at risk when the algorithm abruptly switches around…
For many people, a pullback is a warning sign – a time to take a step back and reassess the market outlook.
However, algorithmic trading isn’t run by human emotions. Instead, algorithms are often programmed to buy into any weakness as long as the prevailing uptrend remains intact. The logic is that a cheaper entry price offers the chance of a higher reward.
Another phenomenon that affects these market dynamics is the rise of volatility-based funds. When volatility is falling, they typically increase their exposure to “risky” assets like stocks, and vice versa.
That’s why so much of the recent rally coincided with volatility indicators, like the CBOE Volatility Index (VIX), tracking around yearly lows. When volatility drops after a pullback (exacerbated by algos buying the dip), these funds buy into the market, adding to demand.
In effect, these different strategies feed into a constant loop, sending stock prices higher. That’s why pullbacks reverse so consistently.
But the same forces driving stocks higher pose a significant risk when sentiment shifts…
The same characteristics that propel stocks higher in an uptrend can play against the stock market when algos start working the other way.
Algorithms programmed to buy weakness can quickly become sellers if momentum turns negative. Likewise, the volatility-based funds that bought stocks when volatility fell become sellers when volatility starts to spike.
This is why traders need to remain cautious.
Markets can quickly go from an abundance of buyers to a shortage of them. If you’re relying on algorithms to buy the dip, you can get burned when selling takes hold.
Once algos go into sell mode, each counter-rally against the prevailing downtrend will give them an opportunity to sell.
So in a downtrend, the algos won’t bail you out anymore. That’s why it’s vital to keep an eye out for the sentiment shift – ideally, before it shows up in the data.
It also reinforces why good risk management is never a bad move – and can save your skin when the market’s rally finally goes off the rails…
Happy Trading,
Larry Benedict
Editor, Trading With Larry Benedict
Reading Trading With Larry Benedict will allow you to take a look into the mind of one of the market’s greatest traders. You’ll be able to recognize and take advantage of trends in the market in no time.
