Friday's Market Minute: Think Like an Algo… No A.I Required

Algorithmic trading, or "algos," has been the “Boogie Man” for traders the past 20 years. When the market appears to behave "irrationally," experienced traders tend to blame algos rather than the fundamental or technical setup, economic developments, or geopolitical risk. However, it's easier to blame algorithmic trading than to recognize changing market conditions. 

Yesterday, the S&P 500 or the SPX had its first green candle after 7 down sessions. Before the technicians try to correct me, these down candles are the opening price of the SPX, compared to the closing price of the SPX in that session. Most major technical analysis educational material stresses the importance on opening values and closing values. Guess what, “Algos” are taught or “trained” on the same concepts. 

The probability of experiencing an 8th consecutive down day was low, and algorithms were calculating the same odds. Although significant low probability events are rare, they are essential when they occur. Therefore, some algorithms place trades in a way that discounts the low probability event. That doesn't mean that they bought with conviction since the volume was notably lower than the five-day average.

Moving averages are a simple yet critical part of algorithm trading. Machine learning or artificial intelligence programs are trained on trying to find the best moving average or a combination of averages that can predict future prices. Since traders have used these moving averages in the past and they have proven to have some significance, algorithms are also using these averages to identify trends. Remember that algorithms are trained on the data that humans provide. 

The S&P 500 touched or got within four points of the 200-day moving average 3- times in the last five trading sessions, before bouncing back up away from the average. This is not a coincidence since breaking the 200-day moving average is a significant market event that traders know is a psychological level. Once again, this does not mean there is conviction or volume to confirm a confident reversal. In fact, volume has been relatively weak on upward moves this week.

These are just two examples of technical indicators that we all follow but there are thousands of different datapoints that can be used to identify trends. Sometimes we lose sight of that because of emotion or the need to rationalize our own ideas. At the end of the day we’re all just trend followers. Us humans and the algos, and once a trend breaks, uncertainty fuels anxiety, creating volatility, which will only subside once a new ‘trend’ is identified.

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