Cyclical sectors like cement and sugar are insulated from algorithmic trading to some extent.
One of Dow Jones News Services’ new 2010 products was called Lexicon. Lexicon offers real-time financial data repackaged to be user-friendly. The USP is that its target users are computers. Lexicon’s data-formats are easily machine-readable and they can be directly parsed to fuel trading decisions made without human intervention.
Over the past two or three years, algorithmic trading has become dominant. Estimates indicate that over 70 per cent of global trading volume is generated by unsupervised computers. Hedge funds and other quant traders have done number-crunching for decades but this is silicon decision-making.
It isn’t only technical price-volume data that is sliced and diced. Some programs make fundamental buy-sell decisions. Others mask actual institutional attitude by executing rapid-fire, high-volume “flash” trades. Still others are designed to decode flash trading patterns!
How does this change the playing field for small players? For one thing, computer algorithms respond blindingly fast. Most short-term arbitrages are exploited before humans even realise that they existed. You are likely to get killed trying to “scalp” in an algorithm-driven market.
The hyperspeed can also cause unpredictable pockets of volatility, when thousands of algorithms interact, causing interference and reinforcement. The May 6,2010 blip on the Dow Jones Industrial Average (DJIA) is labelled the “flash crash”. The DJIA opened at 10,868 points. In mid-session, it lost 1000 points in just five minutes. This was followed by a five-minute pullback when it regained 600 points. It eventually closed at 10,520.
The slide originated with an erroneous trade in Proctor & Gamble. But hi-frequency algorithmic trading reinforced volatility in both directions. If your trading methods don’t allow for this sort of sudden tsunami, you could be in trouble.
Algorithmic trading is already prevalent in India. It will become more popular and mainstream as more contracts become available in forex and commodities. It will also generate more volume in equity and equity derivatives. It might be a more visible phenomenon in 2011
There are several viable ways to adapt - in the broadest sense, whatever your preferred trading or investment methods, you should check to see if they will be impacted by a computer that trades the same way, only more efficiently.
If the market gets “quicker” and short-term opportunities disappear, don’t fight it. Lengthen your trading timeframes. Algorithmic trading shouldn’t make too much of a difference to a trader working on a timeframe of five sessions plus.
For the long-term fundamental investor as well, the algorithms may make a difference. If his preferred investment signals are replicated by computers backed by deep pockets, he may encounter a “herd effect” when the stock he was intending to buy tomorrow jumps in price today.
That herd effect can be a good thing. Most investors, especially ones focussed on value, try to buy with a safety margin. One major problem for such an investing style can be the long wait before the market wakes up and realises that a stock is trading undeservedly cheap.
Here, being on the same side as a popular algorithm may reduce the waiting period and even create higher “strike rates” if the same stocks are being picked by the silicon monsters. Also, if you know the approximate levels at which the programs start booking profits, you can calculate exits better. But this does require awareness and adjustment and that won’t be easy for everyone.
Algorithmic trading might be a likely theme in 2011 but it won’t change the contours of long-term trends. It hasn’t in other markets and India is a pretty evolved market with a fair degree of liquidity and depth.
Unfortunately from the value investors’ perspective, 2011 doesn’t look as though it’s going to be a very happy year. Through 2010, most sectors made gains despite rising inflation and interest rates. Right now, average valuations are much too high for comfort and interest rates probably haven’t peaked. Finding under-valued stocks is difficult and it's anyone’s guess how long the trading momentum will remain positive. A deep correction could be on the cards.
There are two cyclical sectors that may be worth a look. Cement seems undervalued relative to the market. This could be because end users in the realty industry are struggling. Also infrastructure is starved for project finance and project construction contributes a large share of cement offtake.
The other interesting cyclical stock may be sugar. It seems to have gone into another upswing in terms of prices and unlike many other agro-commodities, there are plenty of listed plays. Both tend to be industries with long trending cycles so they are, if not immune to algorithmic trading, somewhat insulated.
