This article was written by Lior Nabat, CEO of Tradency.
‘The wisdom of the crowd’ is defined as the collective opinion of a group of individuals rather than that of a single expert. In our trading industry the wisdom of the crowd is portrayed by what we have come to know as ‘social trading’. Social trading has proved to be ineffective in the trading arena. Why is this so?
There are 4 core elements that are essential in order to turn the wisdom of the crowd concept to a real working model:
1. Information Gap – propagation of critical information related to trading decision
2. Timing – when to get in to follow a good strategy/expert and when to get out from an ill performing strategy/expert
3. Quality – the quality of the strategy/expert should be good for a long period of time (sustainability)
4. Quantity – the ability to provide the same service to any amount of consumers at the same quality
Let’s analyze these 4 core elements from the perspective of the trading industry:
Information gap – propagation of critical information
When a taxi driver tells you that now is the time to enter the market, this is definitely the time to get out. It is commonly known that significant information regarding a specific asset can be used in favor of the trader only when these two conditions are met:
1. The consumption of it is done in close proximity to the release
2. Nobody knows about it
As an example, let’s look on the HFT (high frequency trading) firms that are considered very profitable. The core function of the trading strategy they are using is to identify the abnormal behavior of an asset and to exploit this information as soon as possible (by a massive amount of trading) and in very highly secured infrastructure.
In social trading none of these preliminary requirements exist. Many of the experts are consuming the information from public sources which are often already reflected on the asset’s price (charts for example) and there is no secrecy element to be used.
Timing – traders are always late to get in and always late to get out
We have seen, following many years of close observations, that traders are typically very late to select a good strategy/expert due to lack of education, slow propagation of performance data and lack of time to invest in research and analysis. Furthermore, after the strategy/expert performance starts to degrade, traders often tend to fall in love with the strategy/expert hoping that the performance will improve and they are reluctant to drop the strategy/expert. As a result, most traders are always late to join in on a good trading opportunity (strategy/expert) and are most likely late to get out.
Quality – strategy/expert should perform well at any time
If you enjoy good food, you probably heard about a good restaurant from your friends via various social channels. Most of us are taking into account that if many people are satisfied with a particular restaurant then we should probably check it out and the level of expectation is accordingly high. One of the most challenging tasks for restaurant owners is to maintain a very high quality of food and service for a long period of time in order to use the social effect to propagate and increase the awareness of their offering.
Filling the Gap Between Brokers, LPs, and ClientsGo to article >>
In trading, the requirements are the same; the strategy/expert should perform well for a long period of time in order to be known and be used. However, we all know that the probability of one strategy performing well in any market condition at all times is close to none. Searching for a high quality strategy is time consuming and requires significant amounts of education and learning.
Quantity – when there is not enough liquidity (‘food’)
You heard about a good restaurant and you have decided to go and check it out. In order to preserve high food quality and service the restaurant implements a dedicated reservation system since the restaurant cannot accommodate any amount of diners in any given time and still provide the same quality and business model. For example, look at Noma which is considered to be one of the best restaurants in the world and on the other hand performs as a typical fast food restaurant.
The same scenario applies to the financial markets. When many traders find a good strategy/expert often according to the ‘herd effect’ there is an inflection point where many traders are trying to get a ‘piece’ of the market at the best price at the same time. In many cases there is not enough ‘food’ to feed the requests coming from the large amount of traders thus the performance of the strategy/expert degrades and the traders get frustrated.
So how we can use some of wisdom of the crowd elements in financial trading?
Machine Trading – use the power of computers
By using computer power, you can reduce the information gap, increase the power to identify a good strategy/expert well before others do, and gain the ability to analyze large information of potential strategies/experts.
Large pool of liquidity – high quality ‘food’ at inexpensive prices
By trading on a large and well respected trading platform you are gaining two benefits:
1. Competitive execution price – more close to the ‘big boy’s’ liquidity pool
2. Large trading size without slippages – same quality ‘food’ in large portion
We live in a connected world and the financial arena is not an exception to this new world. But at the same time that social networking and wisdom are beneficial to our day-to-day leisure and lifestyle decision making, it has a potentially damaging effect on our financial trading decision making.
In order to surpass these difficulties, we need to innovatively exploit some of the classic social networking elements and implement them with high-end technology.