Cause and Effect: How Market Volatility Breeds Innovation

by Walter Peczon, EVP of Sales

The global economy is teetering within unstable financial markets.  

As world financial indices first began to down-turn in March, market events and regulatory updates have kept investors on edge, and the gap between worry and hope has narrowed.

However, in some cases,  market volatility can stabilize the economy by correcting positions, providing liquidity, and improving overall market health through diversification.

We wanted to explore how the recent market volatility has helped financial professionals support their customers:

  • How do financial professionals leverage market volatility in their favor?
  • In what ways can volatility give back to the economy?
  • Why is market volatility an essential ingredient for fintech disruptors?
  • Why is market volatility an essential ingredient for fintech disruptors?

Remember the 2008 financial crisis when innovations such as Robo-Advisers surfaced within the financial services industry? Roboadvisers provided ordinary investors access to the market while allowing more liquidity to flood into the market. This is an example of when a new market disruptor enabled a new means to predict opportunities within a volatile market. In this case, the market disruptor lowered the threshold for market participation, enabled new financial tools to be developed by breakthrough start-ups, and helped financial pros to identify new strategies in asset management.

We’ll look at the causes of market volatility, what the effects of such trends can have on leading indicators of the economy, how lagging indices play a role in foreshadowing market shifts, and potential solutions that can elevate players in the securities trading space.


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The Causes of Market Volatility

Defined as the rate at which the value of an asset rapidly changes over time, volatility is often used to determine the assumed level of risk an investor (or trader) will gain when placing a market order. Given this information, trading firms can better anticipate potential returns or losses during a volatile market.

The current and extended market volatility during the pandemic is a good example of a catalyst that triggers market actions:

  • Trend reversal fluctuations that drive bull markets into bears territories
  • Large equity swings in the stock market as cash flow is shriveling for large institutions
  • Elevated levels of risk being displayed by the VIX (short for Volatility Index, which is a real-time market index that represents the market’s expectation of forward-looking volatility, provides a measure of market risk, and gauges investors’ sentiments).

As these warning signs emerge, the challenge is to pinpoint exactly why a market can become volatile, since there are various factors. As an example, Congress voted down the bank bailout during the 2008 financial crisis, causing the Dow to go from up 500 points to down 900 points within seconds. Although the market rebounded from this announcement, the gains that were made after the rebound was lost due to other volatility triggers, such as the closure of Lehman Brothers.

Additionally, other government actions that impact market volatility can include taxes, tariffs, federal spending, and beyond.


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The Effect

Major disruptions within the financial industry began to take shape due to the pandemic. State governments started mandating operational shutdowns within public and private sectors. The New York Stock Exchange was forcibly shut down in response to the outbreak for a period of time, forcing market makers and brokers to transition to a home-office trading desk.

Multiple institutions raised their alarms and prepared for the worst as the virus continued to spread. Financial institutions began to exhaust their capabilities as panic sets in the markets, with positions dropping like flies and corporations seeking emergency support from the US government.

As an effect, the market down-slide from the initial volatility was a huge blow to investors and corporations. In mid-March, the Dow Jones closed at 20,188.52 while the S&P 500 dropped to 2,386.13 and the Nasdaq Composite closed at 6,904.59. This amount of negative movement has been coined as the markets’ worst day since the “Black Monday” market crash in 1987.

Volatility can generate a depth of an effect that is greater than we could imagine. For example, the first week of trading after the tragic 9/11 attacks saw the market fall 684 points, a 7.1% decline, setting a record at the time for the biggest loss in exchange history for one trading day. We saw the biggest losses in NYSE history after 9/11, as the Dow Jones was down almost 1,370 points, representing an estimated $1.4 trillion loss in value in those five days of trading. Ultimately, the market rebounded after just a relatively short period of volatility, but the lasting effects of 9/11 still lingered afterward.

The speed at which this pandemic has brought chaos upon financial professionals has been alarming at best. However, these battle-tested individuals have successfully planned and executed hastily in such a short time frame. They have discovered innovative ways to absorb and cultivate market instability in their favor, allowing them to respond effectively against the crisis.


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The Solutions

A hole in the bottom of a water-filled bucket will leak water, rendering the product nonoperational and no longer viable. However, if you roll on some industrial tape over the hole, it will prevent the bucket from leaking anymore water. Like the industrial tape, chaos breeds invention. In today’s market, financial professionals must be able to identify opportunities during market volatility, and also control risk (the industrial tape).

When markets start to slide, the agility of active management (whether a traditional manager or roboadviser) can become a competitive advantage for investors. Passive strategies may have seen a downturn during this volatility; however an influx of capital has also been experienced in roboadvisers, which has added more liquidity to our markets. Active managers who held cash added some protection to portfolios, with the hopes to re-enter the market when volatility has subsided.

Innovative technology has enabled some market timing techniques an opportunity to shine during this recent volatility.  “Because we’re not active managers, our clients use our software to manage their portfolios,” says Terry Dolan, principal at Southern Trust Securities. Terry mentions that active management can be a key success driver in a platform that is traditionally seen as passive management.

An interesting event happened in the early year though; since the software itself is risk-based driven, it detected that something was wrong around the time of December. Our algorithm got all of our clients to sell off 50% of their holdings and go to cash. In March, when the DOW slipped, the software kicked in and put the cash back into the market, so a lot of our clients are up money versus being down.”

Tighter spreads, lower volumes, and longer resting times are the key goals to be found after market volatility dilutes. Utilizing an automated asset management platform has the potential to elevate an investor’s position in the market.

“Wealth advisors and investment managers must remind their clients that market volatility is a part of nature,” says Michael Higgins, chief executive officer at Velox Clearing.

“Year after year, their clients are content with steady portfolio returns since they’re met with little volatility – meanwhile, their portfolios are being adjusted for abnormal risk over time. A good advisor will calculate volatility, such as the pandemic, into their clients’ growth plans.”


What We Can Gather from Market Volatility

Creating an innovative financial technology solution is no easy task, and there is no roadmap to differentiating yourselves from the many roboadviser platforms available today. Whether your strategy is active or passive, automated or manual, what is key to evolve within the industry, is to adapt to volatility and instability for an investor’s advantage.

Market volatility can be your friend.  New financial products, new government regulations, and new trends within asset management could potentially result from market instability. The best we can do as financial professionals are to strategize our adaptabilities and prepare accordingly.


The exclusive version of the original article can be found on FinTech Direct.