Technology edge for traders

The coming of the internet transformed financial trading in unimaginable ways. It allowed financially sensitive information and rumours to be disseminated at unheard-of speed to much larger audiences. It triggered a drop in transaction costs.

As online trading platforms became more common, an entirely new class of online retail trader appeared. Many of the new traders were mathematically competent and capable of developing programs to do their own real-time number-crunching. While they had small individual accounts, these small, nimble traders also shared their ideas and as a result, momentum trading saw a quantum jump in scale.

Social media has also had a big impact in the last three years. Retail traders are now even more connected to each other. Any titbits of information, right or wrong, are shared instantly and debated in great detail.

A trader with a tablet can access real-time data, run calculations and perform trades while simultaneously discussing tactics with friends on Instant Messenger, Facebook and Twitter. Since connectivity, especially mobile connectivity, is still increasing and mobile processing power is also rising, these trends will get stronger.

This "social trading" environment offers a new set of tools for individuals. There are traders' forums and social groups, where strategies and returns can be discussed in detail. There are sites where traders reveal their trades (or at least claim to do so) in near real-time and their results are collated. The more successful traders then develop a "following" of other traders, which means trades made by successful traders tend to be backed by a cascade of momentum trades.

How well does this sort of crowd-sourcing work? It has some obvious advantages. A novice can mirror the tactics of historically successful traders. A novice can also learn the ropes quickly because he has a lot of data and distilled experience available for study and also because he can ask questions and quickly get answers (albeit of varying quality).

Anybody who wants to implement a new strategy can check to see if something similar has already been used and what are the historical results of such a strategy. Often, traders cooperate to do "parallel processing" and design new strategies involving multiple variables. For example, one of them may number-crunch say, volatility data, while another one back-tests a specific set of signals, a third identifies potentially lucrative markets and a fourth integrates the diverse streams of information. Apart from those who are trading with the consensus, contrarians can also gain a better sense of when to go against the market by tracking these social trading networks.

However, the fabled wisdom of crowds often translates into the madness of crowds when it comes to investments. Bubbles and crashes tend to occur when a large number of apparently smart people act stupidly at the same time. This behaviour is more likely in a highly-connected environment, since the impact of a bad trade might be magnified by followers jumping in.

Even a successful trading strategy tends to lose some of its edge if lots of people adopt it. Mirroring a successful trader will very rarely produce the same results because the "follower" won't get the same price as the original trader. In situations when the consensus is wrong, the social trader will be on the wrong side of the market.

A trader who understands the nuances and implications can certainly use social trading tools to improve his returns and accelerate his learning curve. He could, for example, learn how to diagnose bubbles early or be able to access data that helps him to set up refined contrarian strategies.

But he will also need to develop judgement before he can do this successfully. He is quite likely to lose money until he develops judgment. He might even lose more money than otherwise, if he blindly emulates more experienced traders, without understanding the risks of a given strategy.

Stripped of the technological changes, investing is, and always will be a zero-sum game. Somebody makes money on every trade; somebody else loses an equal sum. Social trading cannot change that particular equation.