Outsized Impact of Algorithmic Trading on Small Cap Stocks

Algorithmic trading (algo trading) is a system in which pre-programmed algorithms are developed to execute trades with zero human intervention.? While it’s widely understood that algo trading is pervasive across public markets, their involvement has historically been limited to the largest, most liquid listings.? More recently, the algos have focused their attention further downstream – wading their way into small caps.? Their impacts on small caps may not be fully appreciated:?

• due to the relative illiquid profile of small caps, algos can amplify market moves, especially during bouts of heightened volatility
• their bias towards intra-day trade vs inter-day trade (not taking positions overnight), often results in late day/last second offsetting/liquidating trades, impacting closing prices
• fluid nature of algorithmic trading creates an illusion of liquidity – orders can disappear as quickly as they appear, in contrast to more traditional static order flow.??

These impacts have wide-reaching implications for small cap issuers:

• increased volatility discourages long-term investors
• price movements that don't reflect the companies' underlying financial outlook can deter retail investors from participating in the stock
• volatility and mispricing degrade the ability of small-cap issuers to attract capital

For the concerned issuer, one possible mitigation of price movements in their stock is to hire a market maker.? A competent market maker plays a critical role in mitigating some of the negative impacts of algo trading:

• provides a balanced, two-sided market (ie depth of interest on both the bid and offering sides)
• maintains a tighter bid-ask spread, improving investor confidence and encouraging investment
• acts as a cushion between buyers and sellers, reducing the potential for drastic price swings??