The Dynamics of the Stock Market are Changing for Retail Investors

 

Volatility in the stock market increases the risk of stock ownership and is causing many retail investors to withdraw from the equity investments and explore other alternatives. This stock market volatility is increasing the bid-ask spread on stocks, which, in turn, is causing even greater volatility and drying up liquidity. Even stocks that are normally actively traded, like Apple and Netflix, are less liquid today. The reason for the illiquidity has to do in part with increasing bid-ask spreads. See Tom Lauricella’s and Gregory Zuckerman’s Wall Street Journal article “Traders Warn of Market Cracks.”

Liquidity refers to the ease or difficulty of buying and selling a security. The bid-ask spread is the best way to judge liquidity, according to some traders.

The bid is the price a buyer is willing to pay for a security. The ask is the price at which a seller will sell a security. The difference is called the bid-ask spread, which represents a profit for the broker handling the transaction.

Market makers are securities firms that post bid and ask prices on an exchange. They must honor their bids and asks in order to have a functioning, liquid market.

The two major determinants of a stock’s bid-ask spread are (1) the volume of trading in that stock, and (2) the stock’s volatility. The stock’s price is also said to be a factor to the extent that low-priced stocks often have low volume and high volatility.

According to the article, volume has been erratic and lower in recent weeks (it cites Monday’s volume of 3.7 billion shares on the New York Stock Exchange as an example). But a Yahoo Finance chart of S&P 500 stock index’s volume shows that volume has been basically steady over the last year at about 4 billion shares per day. There have been some spikes and troughs, but by and large it appears to have held fairly steady around 4 billion.

We know, however, that volatility has markedly increased. So, it seems reasonable to conclude that extreme volatility is the primary factor that is increasing the bid-ask spreads and drying up liquidity to the point that traders are referring to this as cracks in the market.

This makes sense because high volatility increases a market maker’s risk in posting bid and ask prices that must be honored. In a choppy market, market makers that are willing to post at all hedge their risk by increasing the spread.

Surprisingly, high-frequency trading has increased during the overall decline in liquidity, according to the article. By some estimates, high-frequency trading accounts for 70% of the total volume of trading. It is a matter of great concern to regulators because it increases volatility and drives away other investors. High-frequency trading is thought to be a major culprit in the infamous flash crash in May, in which prices fell and rose to impossible levels in a matter of minutes. If liquidity is decreasing while high-frequency trading is increasing, as it seems to be, what possible justification can there be for allowing them to continue to disrupt financial markets?

Retail investors need to be cautious during these times. The extreme swings in the market can be very dangerous.

Page Perry is an Atlanta-based law firm with over 150 years collective experience representing investors in securities-related litigation and arbitration. While past results are not indicative of future success, Page Perry’s attorneys have recovered over $1,000,000 for clients on more than 45 occasions. For further information, please contact us.