Stock Market Volatility

This dumb question is provoked by the recent volatility in stock markets.

Why are the markets so volatile, and what does it mean?

The answer is in a book: Why Stock Markets Crash, by Didier Sornette, subtitled Critical Events in Complex Financial Systems. Princeton, ISBN 0-691-09630-9 in my copy.

Printed in 2003, the book is a scary prediction of the last and current episodes of market volatility. (I have enough mathematical background to be confident that the technical parts are correct.) One main breakthrough is the discussion of “herd behaviour”. Imagine a large boat is listing because all the passengers are on the top deck on the same side. If they can detect this at the same time, and all rush to the high side, they can actually increase the tilt in a dangerously expanding range.

Stock markets are like this. Particpants are connected and follow each others’ leads. Sornette points out that the network of connectivity, its topology, is not as important as its effectiveness. More connections, and faster connections, overrides small weaknesses in the weaving of the web of interactions.

I can be forgiving for suspecting that program trading exacerbates this potential instability. Especially with “limit orders” such as a speculator might use to protect a stock position. Short sells in particular tend to be covered by stop-loss orders, for example.

The book’s conclusion is roughly, increasing swings of increasing frequency are a danger sign. Systems that look like they’re heading for infinity actually break before they get there: a crash.

Disclaimer: I have no financial interest in this book, its author, or its publisher.

Leave a Reply

Your email address will not be published. Required fields are marked *