Events which put a significant impact on the economy and financial markets are imminent. Be it the sudden events or the planned ones, the market fluctuations take place with each. In this article, we have discussed the impact on financial markets and performance of algorithmic traders during such market events.
This article includes:
- What is a market event?
- Impact of an event on financial markets
- Planning algorithmic trades in each market event
- Black Swan
- Grey Swan
- White Swan
What is a market event?
A market event is anything significant that can affect the markets in terms of price movement, volume or market microstructure, like referendums or surprise regulatory decisions.
There are three types of market events:
- Black Swan - Such an event is unpredictable and occurs all of a sudden. It usually leads to a negative impact on the financial markets. For instance, the financial crisis between 2007 and 2008 was an unpredictable event that led to extreme stress in global financial markets.
In the image above, you can see the VIX volatility index showing various Black Swan events that shook the financial markets in the past. VIX or the volatility index is basically a measure to find out the market volatility and hence, is also known as “fear-index”.
VIX is showing the rise in market volatility during each event.
- Grey Swan - A Grey Swan event is likely to occur and is significant also. But the probability of occurrence is low. Hence, certain judgements are formed. For instance, climate change is an event that can happen but there are fewer chances of it happening at a particular time even after the forecasts.
- White Swan - White Swan is an extremely simple event where the event is predictable and the outcome is known. For instance, economic growth can be predicted with the help of GDP growth rates and the result is increased national income.
Impact of an event on financial markets
High price volatility, huge losses, more profit opportunities for some firms (example, sanitization sector during covid)
A sudden collapse may or may not happen depending on nature of event
May result in default because of less money supply in the economy, high debt rates
High price volatility, less losses owing to risk management practices and profit potential is extremely high
Collapse may or may not happen depending on the nature of the event, manageable owing to a mild probability of the event
Lesser chances of default owing to mild probability of the event
Low price volatility, less losses owing to risk management practices and less profit potential
Collapse may or may not happen depending on the nature of the event, manageable owing to a high probability of the event
Less or no chances of default owing to high probability of the event
Planning algorithmic trades in each market event
Algorithmic traders program the algorithms to trade favorably since risk management is imminent in each event. There are a lot of algorithmic trading strategies such as market making, arbitrage, etc. that help to avert the possible losses in case of each Swan - Black Swan, Grey Swan or White Swan.
Also, the buy and sell orders such as market order, limit order, stop loss order are executed to avert losses. Algorithms can be programmed to hedge against the losses as well.
There are three market events that we have covered:
- Black Swan
- Grey Swan
- White Swan
Below, we have discussed the example of each market event and performance of algorithmic traders with regard to trading in different financial markets.
Since we know that a Black Swan event can not be predicted, the traders do not get the chance to plan the trades in the financial markets. But in the case of Grey Swans and White Swans, it is possible to trade in various markets to evade the losses.
Example of a Black Swan
The Fukushima nuclear disaster was an accident that took place in a nuclear power plant in Japan. It was one of the most severe nuclear accidents which led to health hazards for the public.
Ever since then, the share prices of a firm relying on nuclear power for its operations have been much lower than other firms not dependent on nuclear energy.
Similarly, any such event which leaves a huge impact on the economy after occurring all of a sudden is termed as a Black Swan.
Performance of algorithmic traders during a Black Swan
Algorithmic trading helps in such events because the time taken to react to the sudden market fluctuations is less. In case of a sudden uneventful situation like Fukushima, the share prices fall unexpectedly.
In such a scenario, algorithms (pre-programmed instructions) react quickly to the market patterns and execute buy and sell orders within milliseconds. Algorithms perform by executing the most favourable orders in stocks, derivatives and bonds on the basis of the impact.
Example of a Grey Swan
A natural disaster like a tsunami can lead to losses toward the coastal regions. The destruction to premises, stock, machinery, facilities, transport networks, supplies and loss of staff can have a huge impact on the businesses, transport, tourism, fisheries, agriculture etc. Hence, the share prices of the firms relating to the affected sectors decline.
Similarly, we can say that the probability of robots taking over the services such as courier, retail services, receptionist etc. across the globe in 2021 is low but there is a high probability of this happening in near future.
Performance of algorithmic traders during a Grey Swan
In case of Grey Swan, the likelihood of an event is there, although the probability is less. This situation is taken care of by the algorithmic traders by planning in advance to avert the possible losses.
Algorithmic traders plan for such Grey Swan events in various financial markets in the following manner:
- Stock market - The stock market traders remain ready for a bearish or a bullish trend which can occur after a Grey Swan takes place. Traders can invest some shares in the less volatile stocks based on the historical analysis.
- Bond market - Bonds are less riskier than stocks. Bonds can help to diversify the portfolio in case of a decline in the stock market. There are some commodity backed bonds also such as metals (gold, silver, etc.).
- Derivatives market - Lot of funds get parked in derivatives (forwards, futures, options and swaps) when the market is likely to be volatile at a particular time period. A derivative can be matured on a date during the time when the volatility is expected to be high to help avert the losses in case a decline in value of underlying asset takes place.
Example of a White Swan
An increased national income (White Swan) is expected after some situation like a decreased repo rate. Conclusively, the stock market will experience a rise because of an increased national income.
Conversely, a decrease in the national income is expected in case of an increased repo rate and the conclusion will be a dampening effect on the stock market or a decline in the stock market.
Performance of algorithmic traders during a White Swan
In case of White Swan, the algorithmic traders know that there is a high probability of the occurrence of an event and thus, plan the execution of trades in advance.
Algorithmic traders create the algorithms with the trading strategies such as Sentiment Analysis to execute the trades when such an event occurs. Algorithms react to news much faster than the manual traders. For designing trading strategies, Twitter feeds are also used.
Traders use the following ways to avert losses in a White Swan event:
- Stock market - The algorithmic traders keep the volatility at bay with help of certain measures such as limit orders and stop loss orders in such an event which is highly predictable
- Bond market - Since the event is highly predictable, trading in bonds is the best thing to do. Stock market becomes highly volatile in case of an event such as a rise in sales tax, consumer tax etc.
- Derivatives market - Derivatives help lock a price of the underlying asset despite any fall in the prices. Traders invest in the derivatives for safeguarding against the fall in the value of assets.
Important and useful resources to learn about Market Events
- Find out more on risk management in trading with this webinar recording about Risk Management: Maximizing long-term growth.
- A beautful read - Respecting the Grey Swan: 40 Years of Reputation Crises
- A research paper by Nassim Nichola Taleb - The Roots of Unfairness: the Black Swan in Arts and Literature
- There are many quantitative trading strategy models which algorithmic traders apply for coming out of tricky events which make the markets volatile. Learn these strategies here.
We learnt about the three market events that render a huge impact on the financial markets - Black Swan, Grey Swan and White Swan, and the performance of algorithmic traders in each of these market events.
There are different financial markets in which the funds can be parked for coping up with a sudden or a planned market event. Also, algorithmic traders perform in each market event with a trading strategy that helps to limit or evade losses.
If you wish to start learning basic technical trading strategies, like the trend based strategy and the Bollinger bands strategy, and implement them in the Live markets, be sure to check out this course on Quantitative Trading Strategies and Models.
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