Short-Termism Rules

On Friday afternoon, I was asked about the market’s remarkable ability to routinely shrug off seemingly negative news.  I offered my now-standard rejoinder, that momentum and fear of missing out (“MOMO” and “FOMO”) have become so ingrained in investor behavior that any downbeat stimuli can be swiftly tuned out.  Over the weekend I gave more thought about that question and feel that a more nuanced answer is warranted.

An important way that momentum is reinforced is through the relentless “buy-the-dip” behavior that has come to the fore.  Part of this is human nature, part of this can be related to the nature of algorithmic trading. 

The human nature aspect is something we’ve discussed before.  Dip buying has been a perennial winner for many investors and traders.  If the combination of “buying dips, chasing rallies, and adding leverage” proves to be a winning strategy, it makes sense to remain committed to it.  We have opined that the “half-life” of dips seems to be getting ever-shorter because traders are so loath to miss a buyable dip that the race to catch them has caused the dips themselves to shrink.  It is tempting to think of this as pure short-term thinking, but after working spectacularly well for longer-term investors in April, the time frame is not necessarily limited to hyper-aggressive short-term traders.

That said, the algorithms may instead be contributing to the short-term bounces.  An article I read this weekend clarified my thinking on the topic.  The piece pointed out the growing divergence in market exposure between human and computer-driven investors.  Put simply, the algos are quite long while the humans are not. 

Having spent over two decades helping manage a multi-billion dollar, algorithmically driven options market-making operation, I could immediately see why this could be the case.  It is important to remember that algorithms tend to codify human behavior amid a rule set.  Many, if not most, algorithmic trading strategies fall into a few key categories, with trend following, countertrend trading, and correlation/dispersion being among the most popular starting points.  Any guesses as to which is likely to be the most consistent winner in this environment?  

Trend following strategies tend to reinforce moves that are already in place by executing long and short trades depending upon the trend’s direction.  The stronger the trend, the more “conviction” the algo has for that trend.  It would look for signs that either the stock or commodity in question is temporarily above or below the trend and will either initiate long or short positions or close out existing positions based on the parameters of that algorithm.  More aggressive strategies might seek out nascent trends and jump in once a parameter is triggered, amplifying the prevailing move.  There are innumerable variations, but it stands to reason that if human investors recognize that “the trend is your friend”, so will algorithms. 

At the same time, traders have never had so many products available to help them capitalize upon short-term trends.  Options with daily expirations, so-called “0DTE” options have become increasingly popular tools for speculators.  According to the Cboe, the sole venue where index options on the S&P 500 (SPX) currently trade, 0DTE options recently made up over 60% of the volume in the SPX complex.  Remember, these products didn’t exist until 2022, so they could certainly fall into the ever dangerous “it’s different this time” category.

Never has it been easier for all types of traders to enter trend-amplifying positions using cash-settled products with inherent leverage.  In 2021 we wrote about how traders were taking advantage of Friday-expiring weekly options in SPY to help goose the index higher.  Now they don’t have to wait until Friday.  Also, traders have discovered the benefits of speculating with cash-settled options like SPX – as opposed to physically settled options like SPY.  We explained this in September 2022, just as 0DTE options were arriving:

The difference with index options [as opposed to options on ETFs] are when they expire, you’re done. You either made, you lost, you owe the money, you receive the money. Those by the way, typically expire on Friday morning, not Friday afternoon. They’re AM expiration, not PM expiration typically. But the key is you don’t find yourself needing either to hedge or to manage a position Monday morning. I’m talking Friday expirations here, so that’s it, you’re done. 

Thus, we can see why short-term thinking has seemingly come to rule the market’s mentality.  It tends to work, and it is increasingly simple to execute.  That said, no strategy is foolproof.  When looking for early examples of our comments about buying dips, I came across one I’d written entitled “When “Buy the Dip” Doesn’t Work”. The date was February 26, 2020.  Sure, the mother of all dip buying opportunities came a month later, but only after an eye-watering sell-off of nearly 50%.  Buying the dip can morph into catching a falling knife at very inopportune times.