IMPACT OF FEEDBACK
TRADING ON STOCK PRICES.

 

      Feedback trading is the analysis of the
stock market prices overtime and making decisions based on these trends with a
forecast of price persistence in the market. In other words, it’s  the process of making investment decisions
based on stable past market prices with expectations of profitable future  returns.

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There are two main types of 
feedback trading that is positive feedback trading which is an investor
buys stock when the market prices are rising and sells them in a falling market
prices. There is also  the negative
feedback trading where the investor follows the investment strategy that is to
say he or she buys stock when the prices are low and sells the stock when the prices
are high. Positive feedback trading is much inclined or majored in medium sized
firms on buy side but in small and large firms in sell side.

  
Generally, the  presence of
feedback several or many feedback traders in the stock market results to autocorrelation
of returns and this leads to prejudiced predictability of total stock returns.

 

Behavioral finance reviews gives a
large number of theoretical models of feedback trading ,experimental results
and surveys that indeed conclude and point the existence of feedback traders in
the stock markets.

These feedback traders consequently
have some impacts on the stock returns. There has been several theoretical
frameworks overtime that look into the feedback trading for instance
Sentana-Wadhwani(1992), Mech (1993) ,Lo and Mackinlay( 1990), Delong
(1990),Brown and  Cliff 2005,
Brunnermeier and Nagel(2005) among others.

 There approaches tackled different aspects of
feedback trading and how they impact the market or stock prices as discussed
and elaborated below.

 

 

 

 

 

Delong (1990) developed a
theoretical model that explains the bubbling effect of positive feedback
trading. He proposed that for this to occur, there are four key market
participants that is the positive feedback trades, rational arbitrageurs, passive
investors and rational speculators. The interaction of these participants set
market prices.

A passive investor is one who
buys(sells) an asset when its actual value is above(below) is current market
value.

Rational arbitrageurs is a trader
who is able to estimate the actual price of an asset and also to determine the
existence of a passive investor.

Rational speculators  destabilizes prices and hence induces the
positive feedback trading that is they buy stock at an artificially inflated
prices this triggers the market prices to increase causing more speculative
buying.

    
Sentana  and Wadhwani (1992)
suggested  that there are a group of
investors that buy and sell shares depending on past price changes that is the
investor buys or sells the shares when the feedback trading parameter which is
a determinant of trading strategy  is
greater than 0 the feedback is positive. In addition according to sentana and
Wadhwani, there is a strong emprirical evidence of positive feedback in which
majority of investors seem to  pursue
short term to medium trends and the influence of this behavior is strongest
during market downturn.

The impact of feedback trading  is to produce a first order autocorrelation
in stock returns which tends to be more negative as volatility level increases.
During high volatility periods investors tend to increase the price of stock
price.

Feedback trading also have an impact
on cross listed share markets. Abitrageurs and speculators are always paying
attention to the  cross listed share markets
that is those commodities that are in different foreign share markets.
According to Delong , since these two parties are determinants in determining
the price of the shares they will hence have an impact on the share prices. An
empirical study by Dhillon (1997)  finds the volatility for gold futures in the
U.S. market is higher than that of the Japanese market and suggests that the
difference in volatility might be due to difference in information flows within
each of the two markets due to the presence of the feedback traders who may
give misguided information or correct information to investors and this affects
market efficiency and level of competition within the markets.

if the causality spillovers of
liquidity or between liquidity and volatility are significant, they are usually
more likely to exist in cross-spillover effects.

 

There is a certainty that in the
future trading stock markets will be influenced by the feedback trading such
that the future trading destabilizes the underlying markets by increasing stock
market volatility due to uninformed investors presence(cox 1976)

The misinformed investors can
induce noise in the index future markets which decrease information  content of prices.

Future markets may also have  an effect of stabilizing effect on the
underlying spot market because future trading will have improved price
discovery which will promote market efficiency,increased market depth ,market
information flow and this will lead to market competition.

Domination of derivative market by
rational investors ,transmission of volatility from futures to spot markets
will lead to increased market performance .

 

Feedback trading also have an
effect on patterns of stock returns.

According to Koutmos(1997),he noted
that index stock returns tend to be positively autocorrelated in high
frequencies due to risk premia (time variation) or non synchronous.

The The impact  of positive feedback trading in the US stock
market was summarized  by Sentana and Wadhwani
(1992). They deduced that during low volatility periods stock returns are
positively autocorrelated but during high volatility periods they become  negatively autocorrelated.(Koutmos, 1997)

Thus he said that the greater
predicatability that is negative feedback trading injected by feedback traders
are unlikely to produce arbitrage opportunities for rational risk because of
increased volatility.  information
related to destabilized futures prices that positive feedback trading in the
index futures market causes may be transmitted to the spot market through the
process of index arbitrage. the number of institutional investors in the stock
market may be enlarged by the inception of index futures.    This increases the likelihood that more
positive feedback trading would arise.  the existence of an information channel from
futures prices to spot prices and a rising influence that futures prices exert
on spot prices may cause spillovers of information containing noise that
originates from positive feedback trading from futures market to spot market.
The spilled noise may induce investors in the stock market to execute positive
feedback trading strategies.

 

 

  

 

 

 

 

Mech (1993) suggests   that transaction costs can  be an etiology  of positive autocorrelation in stock returns.
Since the  price  of getting new information are high, hence,
prolonging and delaying the delivery of information into stock prices. Since
index contains many stocks, and some of them react on news quickly while others
may not, this results in positive autocorrelation of index returns.

Positive autocorrelation in stock
returns can yield  not only from negative
feedback trading. Another potential explanation 
given in the finance literature is non-synchronous trading. As put
forward or explained by  Lo and MacKinlay
(1990), trade prices of the stocks in the index are taken non-synchronously.
However, the last trade of different stocks may happen at different points of
time. As a result, the value of index is a composition of outdated and present
trade prices. This may induce the positive autocorrelation. The impact of feedback trading on stock
returns results in negative

autocorrelation of returns. The
actions of feedback traders produce predictable returns but this predictability
does not result in profitable opportunities for risk averse “smart-money”
traders since the degree in predictability increases together with rise in risk
level. Moreover, stock market prices go away from their fundamental values as a
result of actions of positive feedback traders utocorrelation in index returns.

 

 

 

 

 

 

                REFERENCES

 

Bohl, M., Reitz, S. (2002) The
Influence of Positive Feedback Trading on Return Autocorrelation: Evidence for
the German Stock Market, Working Paper Series of Postgraduate Research
Programme “Capital Markets and Finance in thenEnlarged Europe”, 1/2002.

DeLong, B.J., Shleifer, A.,
Waldmann, R.J. (1990) Positive Feedback

Investment Strategies and
Destabilizing Rational Speculation, Journal of Finance, 45, 379-95.

Koutmos, G. (1997) Feedback
Trading and the Autocorrelation Pattern in Stock Returns: Further Empirical

Evidence, Journal of
International Money and Finance, 16, 625-36

 

 

 

 

 

 

 

 

 

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