Posted on 01/07/2011 6:38:16 AM PST by SeekAndFind
Wired magazine and the New York Times both recently published detailed stories on "flash trading" - the increasing use of high speed artificial intelligence algorithms in the financial markets. Both asked the same question: Will flash trading help the markets by improving efficiency - or will it destroy them?
But while both stories covered the same basic facts, they took strikingly different approaches. Wired discussed the technology in a generally balanced fashion, whereas the New York Times adopted a more alarmist attitude, including emphasizing the problems the technology would create for government regulators. However, the concerns raised by the Times against flash trading are variations of fallacies frequently raised against free markets. Hence, identifying and rebutting those fallacies will help one better appreciate and defend flash trading in particular, as well as market capitalism in general.
The Wired story discussed how traders are using increasingly sophisticated computer algorithms either to execute thousands of transactions per second (to exploit short-term fluctuations in stock prices) or to data-mine news and earnings statements to find attractive investment opportunities that others might have missed. Because these algorithms rely on fast computing power, they often adopt strategies human supervisors do not fully understand and could never devise on their own. Yet Wired notes that, "The result is a system that is more efficient, faster, and smarter than any human."
Of course, traders using such algorithms must necessarily cede a certain degree of decision-making to their software in exchange for higher profits. But this is no different in principle from a human motorist ceding some manual control of his automobile to his computer-controlled transmission and anti-lock brake systems in exchange for improved gas mileage and safety.
Naturally, the availability of such powerful technology elevates the financial stakes for traders. Traders who devise and utilize robust algorithms can quickly make a great deal of money, whereas those who use poor algorithms can quickly lose their shirts.
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