Outsmart the Stock Market Machines

How to Win Against Stock Market Bots

Strategies to Stay Ahead in an Algorithm-Driven Market

Marcus Padley | 9 July 2024 | Education Corner

I received an email once from a Member annoyed about the market. It went something like this: “What in hell is going on? In my view, the stock market is becoming no place for retiree investors. It’s being influenced by too many forces outside our control or knowledge, things like shorting, computer-based transactions, high-frequency trading, and the activities of complex hedge funds with unfathomable investment objectives, to name but a few.”

Volatility and Investor Concerns

Volatility upsets investors. Since the advent of computer trading and algorithms that chase everything from adjectives in announcements to volatility itself, the frequency of shock drops and big share price reactions has exploded. During the most recent results season, 51% of the two hundred and sixty-odd major results moved more than 3% on the day of their results. 35% moved more than 5%, and 11% moved by 10% or more. Market commentators, especially those CFD trading platforms, rely on volatility to provoke trade. The more you trade, the quicker you lose your stake (it's like the TAB), so they want trades. That's why they’ll tell you that market volatility is an opportunity, as if it’s a good thing. In fact, one of their number has an ad running on the interweb at the moment saying: "Take advantage of market volatility - Our unmatched execution speed gives you the upper hand when it comes to trading. Execute trades in just one millisecond on one of the fastest engines on the market. (Losses can exceed investment)." Yeah right. Those milliseconds are going to make all the difference. Volatility is a massive turnoff for the conservative investor, and I fully understand my emailer because if one investor bothers to write it, you can guarantee thousands are thinking it.

Volatility vs. Safety: Do We Have to Recalibrate?

Volatility undermines the concept of ‘safe’. But do we all have to recalibrate for higher risk and volatility? You'll be glad to hear that the answer is "No".

The Role of Algorithms in the Market

Something like half of all trades are now being done by non-humans, with very short-term goals, using maths, not judgment. Algorithms (formulas on an Excel spreadsheet operated by a computer) have introduced significant volatility, especially on announcements. The good news is that it is almost all short term, and the stuff that is longer-term (read - "A day") is just a computer program doing exactly what a broker would be doing anyway.

Example of a Broker Operating an Order

If a broker is asked to sell 100,000 shares of XYZ by a fund manager, and the stock only usually trades 1,000,000 shares a day. If they just dump 100,000 shares into the market straight away on the open at whatever price, they have to dump it in order to get it sold in an instant. This will collapse the price. In order to impress the fund manager with their "execution" of the trade (the fund manager won't deal with them again if their execution is rubbish), they will want to sell for a good price, not at any price. They know the fund manager will judge them on the price they sell at, and that will be compared to the average price of all trades that day (VWAP - Volume Weighted Average Price). So the broker needs to manage the impact of their selling. They want to keep it a secret. They don't want to show their hand on the screen. The way to do that is to manage the order gently over the day without letting everyone else know there is a big seller in the market. So what they would do is trickle a bit of stock into the bid and then let it build up again, sell a bit more, and hopefully, by the end of the day, the 100,000 is sold without any impact on the price that day. Everyone happy.

Example of a Computer Operating the Same Order

To manage an order gently over a day using a human (the operator - the person who inputs the order at the broking house) requires the human to watch the screen all day. Before computers, they couldn't even go to the loo without handing the order over to another operator. With the advent of computers, the humans can go to the loo. What is commonplace at a broking house now is that you put this sort of order into a computer linked to the ASX trading system and tell it to operate the order in a certain way. The same way a human would do it. So you might tell it something like:

• We have 100,000 XYZ to sell over the day.
• The lowest price you can sell at is X.
• You can only sell 10% of the volume done so far at any one time during the day.

And off it goes. So if 100,000 shares of XYZ trade on the market, it can sell 10,000 shares above X. Now can you see where the "1" share trades are coming from? In an illiquid stock, if 10 shares trade, the broker's computer can sell another 1 share. Now imagine ten computers operating orders in the same stock on the same day, and they all start trading against each other. All putting on 1 share trades which trigger someone else's algorithm to sell another 1 share, and before you know it, you have an algorithm cluster fark. But the humans can go to the loo. Not my fault. It was the computer.

The Unnatural Nature of Computer Trading

A lot of investors tend to think computer trading is unnatural. They don't like those 1 share trades on their screens, they don't like the 20% moves in stocks immediately on an announcement (that's high-frequency trading), and they don't like the thought that a computer is active in their stocks. That they are up against a faster and smarter algorithm and that it is unfair.

What Can We Do About It?

The obvious answer, of course, is that rather than resist it and get upset by it, accept it because it is here to stay. You are going to have to get used to it. Everyone has. It is an everyday fact of stock exchange life these days, and before you think it should be banned, understand that the ASX is earning a lot of money out of the volume of trade, and it’s their stock exchange. So it's safe to say it's here to stay.

How to Beat the Machines

So how do we beat the machines? How do we adapt to a market that is inhumanely volatile and "quick" and at times illogical, with prices moving irrelevant to value and fundamentals? Well, if you can’t join them, beat them. Exploit them (and they are exploitable). By and large, the machines only operate in the short term, and they don't do research. Their primary weapon is speed, and their primary competitors are other computers, not us.

The High-Frequency Trading Phenomenon

Did you know that stock exchanges charge a fortune for high-frequency traders to plug their computers into stock exchange computers? Did you know that those computer stacks are physically in the stock exchange building on the same floor as the stock exchange computer? Did you know that in some stock exchanges, they have had to impose a standard fibre optic cable length for the computers plugged in because, if the cables are longer, the reaction times are a millimillinanosecond slower, which puts that computer stack at a disadvantage? Get this: I used to work at a broking house that had a principal trader who one day asked all the bosses to come to his desk and watch something. He was trading a large ASX stock all day, every day (that's what principal traders do - it's VERY boring). He loaded 100,000 shares to sell and said, "watch this". He pretended to hit the button to sell the stock a few times, and the price stayed where it was on the screen. He then hit the button, and before the stock was sold, the price dropped against him. He did it a few times. It became very clear that some other computers were reading his keystrokes, and even before the order was executed, before it got to the stock exchange system, other computers were jumping in ahead of him. Hence the length of cable rule.

The Reality: Competing with Machines Is Futile

Back to you and your indignation - You can't compete on the speed of trades, and nor would you want to. So the conclusion is - let them fight it out amongst themselves. Yes, they have made it harder to compete in a short-term timeframe, but that’s only really threatening (very) short-term traders and only at the point of execution. It really doesn’t threaten the "investor" with a timeframe beyond the time it takes to make a keystroke.

Playing Where the Machines Don’t Play

To beat the machines as an investor, all you need to do is keep doing what you’re doing, adopt a time horizon beyond nanoseconds and play where the machines don't play, in the medium to long term. The machines aren't long term. They don't take into account changes in underlying value, profitability, fundamentals, the things which create long-term trends and the things which we can, as humans, still anticipate and hopefully exploit with some “edge”. The market is still wide open to those who are engaged, interested, and possess some ability when it comes to researching individual stocks and/or predicting the development of longer-term themes. We still have a chance to exploit an edge and to operate undisturbed. And those 20% drops, or 20% rises? They are not necessarily fundamentally justified. So they may be exploitable.

Short-Term Trading: A Tough Game

Trying to make money in the short term has always been a tough game. The machines just make it more obvious that the short term is a hard timeframe to trade by making it more difficult, volatile, and speedy. For evidence of its folly, the folly of being short term, you can read books like Jack D. Schwager's Market Wizards - it will tell you that almost all professional traders start with one-minute charts, move to one-hour charts, then daily charts, then weekly charts, and eventually end up trading monthly charts. Experience teaches all traders that it is very, very hard to consistently exploit an edge in the short term, and those that survive the learning experience, those that are disciplined enough or rich enough not to get disheartened or wiped out, will eventually learn that you can only really exploit reliable/longer, rather than momentary, trends.

The Simple Answer: Do Nothing

So the answer to the question "What do we do about the machines" is a short one. It's "Nothing”. There are plenty of better things to do than worry about or compete with algorithms driving trading decisions that have a half-life of microseconds.

How to Avoid Stock Market Volatility

One way is to not go near equities, but to seek a risk-free return, or a very low-risk return in bonds and fixed interest. Another obvious solution is to sit your money in a diversified Industry or Retail Super fund and click buttons to change asset allocation (Aggressive, Balanced, Conservative, Cash). But the option I would pursue, if I was a wealthy retiree who’d prefer to avoid the stress of the volatility in individual equities, is to trade a diversified portfolio through exchange-traded funds, although I know a lot of you are still in listed investment companies (same, same, but different - and so 1980's). If volatility is your issue, then investing in an index through a passive ETF has much lower volatility than individual stocks and will give you a far less stressful ride because, of course, the average of 200 stocks moving up-and-down is going to be a lot less volatile than one stock moving up-and-down.

The Case for Passive ETFs

Trading an index or a market is like trading stocks in slow motion. You also avoid the “shock drops” you see in individual stocks. It’s rare that an index crashes, so rare that we all remember when they do. And rather than chasing stocks every day, all you need do is make a few decisions every year, if any, about whether to be in the market or out of the market, and, in so doing, avoid all that bother you go through when managing the volatility, decision making, and paperwork of twenty separate equities. Trading passive ETFs is putting yourself in the slow lane, and this is the ETF industry's best pitch in my opinion. “Stock picking is too hard, buy ETFs”. It’s a bit like Dudley Moore’s terribly successful advertising line in Crazy People in 1990. “Volvo. They’re Boxy but they’re Good”. Index-reflecting passive ETFs are boring but they’re safer. There is still a little bit of brain required, of course; the returns come not from holding an investment in the market blindly, but from timing them, timing your exposure to the markets. We have an ETF spreadsheet available for you, of course, and the terribly successful Strategy Portfolio is all ETFs, but before you head off for a life of relaxation, let me just give you this little warning about trading an index instead of individual stocks. It’s really boring!

Conclusion: Finding Your Comfort Zone

If you enjoy the stock market, trading a low-volatility ETF is probably not for you, there's less action, passion, interest or, amazingly enough, volatility for the ‘ambitious’ investor. But if you want to get back to the gardening and watching the football, maybe you should.

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