The rise of the machines…

One of the more interesting stories I cam across this week was on Bloomberg http://www.businessweek.com/news/2012-11-06/million-dollar-traders-replaced-with-machines-credit-markets) relaying news that at least one, if not more, of the recently sacked UBS traders in the City have been replaced by Algorithms.

It must be pretty hard being replaced by a computer, however, computerisation for productivity improvements is hardly a new trend, although replacing highly paid workers is increasingly worrying for many of us.

As a sign of the market environment to come, it is instructional though. Already in the US over 60% of NYSE trades are computer driven and in the UK over 40% of FTSE trades are initiated by computers. These numbers are increasing all the time. Now other types of derivatives and non-equity markets are being accessed by computer algorithms with massive allocation of funds to their programmes.

This throws up a few dilemma’s beyond the usual what-the-hell-are-we-all-going-to-do-for-a- living? Firstly, the flash crash in the USA showed that in a panic, the mass of computing power creates an even worse herd-like instinct than humans do, and which is quite a feat! In normal markets algo’s outperform humans as they don’t make emotional and irrational investments and have specific limited risk profiles. You just can’t get a computer Kweku Adeboli, unless through some really bad programming!

On the other side, computers models are all built around statistics and technical analysis. They do not look at analysts’ reports or speak to management. They react to the market moves of the day. So in effect, they are perfect momentum traders, better than you or I every time. But they are rubbish long-term investors by design. They can’t see an AIM stock going up 1000% in a year because they don’t know about the drill/patent/buy-out, unless it is quickly programmed into the code – which is nigh on impossible.

All this should mean in the near future that day-trading becomes a really hard game to win on a TA basis; conversely more fundamental strategies around buy and hold or even shorting over decent time periods, will become more efficient once more. Ignoring short-term volatility, better opportunities will arise and in a more liquid market provided by Algo’s there will be more entry points and exit points for positions – particularly so for smaller retail players than for larger companies who need to take bigger positions.

Equity trading has seen large falls in volume of late with the likes of BGC reporting 20% collapses in volumes. Whilst the algo’s have put off many traders for now who are tired of seeing their trades front-run at lightspeed, this situation may eventually turn around as the benefits of a long-term strategy are seen again. The world of trading and investing is certainly moving fast in 2012.

CityUnslicker