Internet Trading and the Impact on Traders and Markets

ZHANG, Michael Xiaoquan | ZHANG, Lihong

Internet stock trading has made it easier for inexperienced and uninformed investors to participate in financial markets. These investors often use online investing systems to engage in “feedback trading” – a strategy based on past price trends whose expected profit averages out at negative. Such an outcome, and the sheer volume of Internet trading, suggests there could be consequences not only for the uninformed investors, but also informed investors and the market itself.

Xiaoquang (Michael) Zhang and Lilhong Zhang develop a model for considering these questions and find that informed traders and the market can breathe easy, but uninformed traders may need some regulatory help to reduce their risk.

First, for informed traders, they continue to have an information advantage over feedback traders who are only looking at past trends, and their expected profits and strategies are unlikely to be affected by feedback trading.

“Although automated trading empowers uninformed traders in terms of lower search and transaction costs and an increased speed of order execution, it does not offer any information advantage. This result suggests that online feedback traders should not outperform their offline counterparts in terms of expected profit,” they said.

Even online traders who adopt more aggressive feedback strategies do not as a whole gain an advantage in terms of the expected profit.

Feedback trading also does not affect the stability and liquidity of the market in their model. “While the use of the Internet is associated with an increase in the frequency of trading, it has an insignificant impact on the trading volume and price levels,” they said.

“Feedback trading does affect the sensitivity of the market to changes in demand, but the speed at which information gets incorporated into price remains unchanged.”

However, the neutral effects of feedback trading do not extend to the uninformed traders themselves, who face risks. “If uninformed traders rely on traditional risk-adjusted measures of profit, such as the Sharpe Ratio, they will increase their feedback trading intensity, but doing so will create much higher risk without increasing their expected profit or reducing their expected loss,” the authors said.

Regulators therefore need to consider how to limit the risks to uninformed traders. This should involve calculating and disclosing risk measures when designing online trading systems, and encouraging uninformed traders to determine their stop-loss level before they start trading, they said.

Overall, though, the impact of Internet trading on the wider market has not lived up to fears that it would create problems for market participants.

“Since feedback trading has a limited impact on the informed trader and the price process, our results suggest uninformed traders’ feedback trading does not pose significant costs to other market participants. The influx of inexperienced feedback traders as a result of the ease and speed of the Internet should not be too much of a worry if market stability is a major concern,” the authors concluded.