Computer Trading is Not the Beast Many Think It Is
There are quite a few people out there who are intimidated and disenchanted with all the computer trading that goes on these days, but these fears are not justified at all.
There is a myth out there that still prevails that has us human traders and investors pitted against an army of computers, all of which can both process information and place trades a lot faster than we can. While this is true, this does not mean that we should be afraid or intimidated or even that this takes away from our results.
These fears have even spread to individual investors who use fundamental analysis to decide what to invest in, and they think that the superior powers of modern-day computing are some kind of threat to what they do, and that these computers even prey on investors somehow in the same way that many traders think that they are being preyed on by them.
If we step back and think about how this process could affect us, it’s not hard to figure out that none of this is really harmful, and if anything, this helps us by providing more liquidity to what we are trading, more action in other words in more common parlance.
Investors being concerned about this is even more far out than traders becoming upset with this although it is at least widespread enough for this to make the news now proposing ways that we may be able to better deal with this trouble. The best way to deal with it, if you are either a trader or investor, is to just ignore it, because none of this really impacts us, save for events such as flash crashes, which are rare.
The majority of trading these days is done not by humans but by computers, and if we just look at this, it does seem that the machines have taken over our stock trading planet. We want more trading to go on though, and whether these trades are placed by man or machine doesn’t really make any difference, even if these new cyber traders can trade circles around us and be in and out of many trades in the time it takes to reach our computer mice or hotkeys.
It is not that we do not see their handiwork on the charts though, and computers help drive a lot of the movement that we see in stocks. If you are a trader, you should be very grateful for these machines as they actually contribute to our potential profitability by both running the price of what we trade further, and this is how traders make money, from bigger moves.
There are still a lot of traders that have had to adjust to this, those who fancied themselves as market makers and used limit orders to try to improve the price of their fills. This is a terrible idea by the way, as we cannot compete with even the human market makers since they hold all the cards and have several significant advantages over us.
What will happen when we try this is that we’ll mostly only get filled with the bad trades, the ones that do not move up like we hope they will, and see the actual good trades pass our limit by. This is like trading on a downtick like shorting requires and doing it on purpose. Even if we manage to get on the current bid or ask, our trades can simply be ignored by the market makers, as punishment for stepping on their turf. This is a terrible way to trade and if something served to curtail people’s desire to do such things, this should be seen as a real blessing, not a curse.
Even with the fast fills that we can get these days, we were out of our league trying to make markets even back before computer trading took off, and we surely are now. There are still people to teach trading that tell their students to stick to limit orders even these days. Over 9 out of 10 new traders fail and do so in short order, and trading is challenging enough without using a style that filters out the promising trades, the ones we want, and concentrates on the ones we don’t want, the ones where price is going against us as we look to enter.
No matter what time frame you are trading on, the goal is always to ride price momentum, where if you are looking to go long you want to go with trades that are moving your way already, with the expectation that this will continue long enough that you will be able to ride it for a while and get out when the momentum wanes enough.
Computers Actually Make It Easier for Us to Make Money Trading
Once we ditch this really dumb idea of placing limit orders, the computer traders that get in before us may get a better price than we do, but our results aren’t tied to theirs and this is not a competitive forum like so many people think that it is. These computers do not win our money, we instead lose it from our mistakes. Computers don’t even capitalize on our mistakes like some may think that they do, as both we and the computers, and every other market participant, follows their own path with all of us chasing price movement and not any particular trader.
Let’s take an example where the price of our stock or other asset is beginning a move in one direction or another. Hopefully we have waited to enter long enough to see enough movement to make jumping on a good trade, and we actually want the computers or whomever else may want to jump in too early to do that first.
We actually want to act at the proper time though, because any delay may end up costing us money, which we call slippage, the difference between the price we see when we decide to place the trade and the price that we end up being filled at. This power is actually in our fingers and minds though.
The more participants there are, the more slippage we may see, although this is actually a good thing generally because when this happens, it means that there is even more momentum behind the play and we’re more likely to get more out of it as the move continues. As the computers place pressure on the move, it will make it both stand out more and become a more reliable signal and others will jump in for a while until we’ve exhausted the positive momentum and risk a reversal enough that it becomes time for us to go.
The speed advantage that computers have is a nice thing in itself, all other things being equal, but the results of using this speed will depend a lot more on the quality of the strategy being used. When we trade with a contracts for difference or CFD broker, there is no lag as we just click on the bid and ask and get an instant fill, because we’re placing our orders directly with the broker and not the market, but we can still mess up trades pretty badly in spite of this speed due to just plain bad decision making. A bad decision, instantly executed, is still a bad decision, and a good one that might take a tad more time to get filled but is still profitable overall is still a good one.
We might think that computers are a lot better at trading than we are, but computers are merely extensions of their programs, and if you are a good trader, you can refine your trades better than a trading bot. This isn’t unlike a good poker player playing against an online poker bot, and even if the bot has been programmed by a player of similar skill, the program simply isn’t written to adapt to the nuances of the game as it unfolds as a strong human player is.
With that said, trading is not a competitive game like poker is, where players are pitted against one another to see who gets each other’s money. Both trading and investing pit us against the market itself, and who holds what doesn’t really factor into things, much like the hands of other players do not matter at a blackjack table.
If a stock moves up a certain amount and then stops, the participants are going to have various thresholds for their exits, and when ours is hit, most of them won’t even care. Among those who are using an identical strategy to ours, which aren’t very many, it is true that the first to the post gets out first, and if things have reversed in our estimation and we are right, computer traders can get a better fill than we do. We are talking very brief periods of time here though and there may be a little slippage but we can still be up by plenty, and this slippage is just the price of doing business.
The downside of this much computer trading is therefore pretty negligible, and even this becomes balanced off by the added liquidity that computer trading provides. If the price is at a certain point when we want to exit, and the computer traders weren’t in the game, this can lead to a worse fill due to less participants and wider spreads.
Spreads used to be a lot bigger deal than they are today, and in the old days you would usually pay an eighth of a point or more. Things have really tightened up nowadays, and you can thank all those computers for this as they have more than doubled the amount of liquidity that we now enjoy.
The overall effect of all this is that it is actually easier not harder to have success trading now, and this is especially the case when we trade with and not against the computers, or rather, see them help us make money by jumping aboard with us and inspiring the humans to put more money on our side as well.
This is why we see trends these days being as distinct as they are, on all time frames, from one second bars to monthly charts. We want and need more of this, because the longer and more distinct a trend is, the easier and more profitable it is for us to trade. We and the computers can both make money from the move, at least the computers and traders that were on the right side of the move, and we don’t care what anyone else makes as long as we do well.
Investors Really Have Nothing to Fear from Bots
While it is understandable how traders might worry about computers, an investor being bothered by this is actually pretty far out. Investors do tend to be less connected with reality than the good traders are, especially those who think that the secret to stock prices can be found in the business results of a company, and then become worried that computers will conjure up some magical approach to fundamental analysis that will not only beat us but prey on our mistakes.
Even if this were possible, like with the concerns of traders, this would be a plus. If we make a bad choice, and they have more insight, they won’t join us in the mistake, unless it is on the short side that is, but this an entirely different game than investors play and we’re not worried about their playing very short-term moves while we’re investing for months and usually years.
Potential slippage won’t mean much to us either, as this ends up being meaningless change to investors, a miniscule portion of their overall expected return, measured in dollars not a few pennies. Once again though, this along with whatever other trading costs involved must be paid for us to invest at all, where we miss out on benefits that are many times greater than what has caused us to not wish to invest. This is penny wise and many pounds foolish actually.
With our good investments, the ones we are right about, we welcome any additional action on our side after we’re in the trade. Whatever has happened in the very brief time that it takes to get our order filled doesn’t matter, but this can serve to lay bait for more of this, and any further action on our side can only help us by making our prediction come true more.
If there are computers out there that can make better investment decisions than we can, through any means, that’s also not a bad thing and is generally a good thing, since their interest will if anything drive the price in our direction more.
Computers don’t actually ever invest though, and the longest time frame that computer trading focuses on is way shorter than any investor would ever dream of. They are day traders on steroids and way beneath the attention threshold of investors, and worrying about them would be like Warren Buffett sweating a bad five minutes when he expects to hold it for years regardless.
There is always a queue of decision involved in both trading and investing, and the best way to illustrate this is to look at what people do when the price turns against them. There are some that are out like lightning, with others being willing to sit through various degrees of movement before they act, right up to those who aren’t exiting for any reason.
Computers could get out faster if they wish, but it’s the when do you wish part that really defines things, when you pull the trigger, even though we might get a tiny bit more lag than the computers and the more connected investors get. There is a game that is played where speed really is king, but this is in the world of market making and is as far away from an investor as you could possibly get, with bots competing for trades that are only held for tiny fractions of a second.
Traders do not have the means to play in this game either, and certainly cannot compete at it with those who build large data centers close to exchanges that use microwave transmission to shave milliseconds off of their execution times and win at this game. These are the dealers in our card game, and we are the ones that get the cards that they deal out, and we need to realize that these are two distinct roles in the game of trading and investing.
We can’t really complain about people using computers for fundamental analysis and being better at this than we are, as to the extent that this might matter, even without computers, we can’t expect to out analyze the teams of professional analysts that institutional investors employ. The good news though is that even the most refined and astute fundamental analysis only portrays part of the picture, one factor among many, and when you take a single input among many and use this to tell the story, you’re going to end up being wrong a lot.
While we do want to ensure that we don’t make the same mistake, there’s nothing to fear at all from programs that are designed to produce results that are based upon a fundamental mistake about how asset prices move in a market. Once again though, this does not even matter, as stocks have a strong bias to the upside and there is plenty of money for everyone that makes good choices, which hopefully includes us.
The less you know, the more there is to be afraid of, and this certainly applies in this case. When it comes to worrying about computers taking over financial markets, the only thing to fear is fear itself. When we open our eyes and shed ourselves of our distorted perceptions, we may even make a friend.
Editor, MarketReview.com
Andrew is passionate about anything related to finance, and provides readers with his keen insights into how the numbers add up and what they mean.
Contact Andrew: andrew@marketreview.com
Areas of interest: News & updates from the Consumer Financial Protection Bureau, Trading, Cryptocurrency, Portfolio Management & more.