Feedback trading is the analysis of thestock market prices overtime and making decisions based on these trends with aforecast of price persistence in the market.
In other words, it’s the process of making investment decisionsbased on stable past market prices with expectations of profitable future returns. There are two main types of feedback trading that is positive feedback trading which is an investorbuys stock when the market prices are rising and sells them in a falling marketprices. There is also the negativefeedback trading where the investor follows the investment strategy that is tosay he or she buys stock when the prices are low and sells the stock when the pricesare high. Positive feedback trading is much inclined or majored in medium sizedfirms on buy side but in small and large firms in sell side. Generally, the presence offeedback several or many feedback traders in the stock market results to autocorrelationof returns and this leads to prejudiced predictability of total stock returns. Behavioral finance reviews gives alarge number of theoretical models of feedback trading ,experimental resultsand surveys that indeed conclude and point the existence of feedback traders inthe stock markets.
These feedback traders consequentlyhave some impacts on the stock returns. There has been several theoreticalframeworks overtime that look into the feedback trading for instanceSentana-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 offeedback trading and how they impact the market or stock prices as discussedand elaborated below.
Delong (1990) developed atheoretical model that explains the bubbling effect of positive feedbacktrading. He proposed that for this to occur, there are four key marketparticipants that is the positive feedback trades, rational arbitrageurs, passiveinvestors and rational speculators. The interaction of these participants setmarket prices.A passive investor is one whobuys(sells) an asset when its actual value is above(below) is current marketvalue.
Rational arbitrageurs is a traderwho is able to estimate the actual price of an asset and also to determine theexistence of a passive investor.Rational speculators destabilizes prices and hence induces thepositive feedback trading that is they buy stock at an artificially inflatedprices this triggers the market prices to increase causing more speculativebuying. Sentana and Wadhwani (1992)suggested that there are a group ofinvestors that buy and sell shares depending on past price changes that is theinvestor buys or sells the shares when the feedback trading parameter which isa determinant of trading strategy isgreater than 0 the feedback is positive. In addition according to sentana andWadhwani, there is a strong emprirical evidence of positive feedback in whichmajority of investors seem to pursueshort term to medium trends and the influence of this behavior is strongestduring market downturn. The impact of feedback trading is to produce a first order autocorrelationin stock returns which tends to be more negative as volatility level increases.
During high volatility periods investors tend to increase the price of stockprice.Feedback trading also have an impacton cross listed share markets. Abitrageurs and speculators are always payingattention to the cross listed share marketsthat is those commodities that are in different foreign share markets.
According to Delong , since these two parties are determinants in determiningthe price of the shares they will hence have an impact on the share prices. Anempirical study by Dhillon (1997) finds the volatility for gold futures in theU.S. market is higher than that of the Japanese market and suggests that thedifference in volatility might be due to difference in information flows withineach of the two markets due to the presence of the feedback traders who maygive misguided information or correct information to investors and this affectsmarket efficiency and level of competition within the markets.
if the causality spillovers ofliquidity or between liquidity and volatility are significant, they are usuallymore likely to exist in cross-spillover effects. There is a certainty that in thefuture trading stock markets will be influenced by the feedback trading suchthat the future trading destabilizes the underlying markets by increasing stockmarket volatility due to uninformed investors presence(cox 1976)The misinformed investors caninduce noise in the index future markets which decrease information content of prices.Future markets may also have an effect of stabilizing effect on theunderlying spot market because future trading will have improved pricediscovery which will promote market efficiency,increased market depth ,marketinformation flow and this will lead to market competition.Domination of derivative market byrational investors ,transmission of volatility from futures to spot marketswill lead to increased market performance . Feedback trading also have aneffect on patterns of stock returns.According to Koutmos(1997),he notedthat index stock returns tend to be positively autocorrelated in highfrequencies due to risk premia (time variation) or non synchronous.
The The impact of positive feedback trading in the US stockmarket was summarized by Sentana and Wadhwani(1992). They deduced that during low volatility periods stock returns arepositively autocorrelated but during high volatility periods they become negatively autocorrelated.(Koutmos, 1997)Thus he said that the greaterpredicatability that is negative feedback trading injected by feedback tradersare unlikely to produce arbitrage opportunities for rational risk because ofincreased volatility. informationrelated to destabilized futures prices that positive feedback trading in theindex futures market causes may be transmitted to the spot market through theprocess of index arbitrage. the number of institutional investors in the stockmarket may be enlarged by the inception of index futures.
This increases the likelihood that morepositive feedback trading would arise. the existence of an information channel fromfutures prices to spot prices and a rising influence that futures prices exerton spot prices may cause spillovers of information containing noise thatoriginates from positive feedback trading from futures market to spot market.The spilled noise may induce investors in the stock market to execute positivefeedback 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.
Sinceindex contains many stocks, and some of them react on news quickly while othersmay not, this results in positive autocorrelation of index returns.Positive autocorrelation in stockreturns can yield not only from negativefeedback trading. Another potential explanation given in the finance literature is non-synchronous trading. As putforward 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 oftime.
As a result, the value of index is a composition of outdated and presenttrade prices. This may induce the positive autocorrelation. The impact of feedback trading on stockreturns results in negativeautocorrelation of returns. Theactions of feedback traders produce predictable returns but this predictabilitydoes not result in profitable opportunities for risk averse “smart-money”traders since the degree in predictability increases together with rise in risklevel.
Moreover, stock market prices go away from their fundamental values as aresult of actions of positive feedback traders utocorrelation in index returns. REFERENCES Bohl, M., Reitz, S. (2002) TheInfluence of Positive Feedback Trading on Return Autocorrelation: Evidence forthe German Stock Market, Working Paper Series of Postgraduate ResearchProgramme “Capital Markets and Finance in thenEnlarged Europe”, 1/2002.DeLong, B.
J., Shleifer, A.,Waldmann, R.J. (1990) Positive FeedbackInvestment Strategies andDestabilizing Rational Speculation, Journal of Finance, 45, 379-95.Koutmos, G.
(1997) FeedbackTrading and the Autocorrelation Pattern in Stock Returns: Further EmpiricalEvidence, Journal ofInternational Money and Finance, 16, 625-36