AI and Trading: Beware the Bots?

08/18/2017 2:56 am EST

Focus: STOCKS

Joe Duarte

Analyst, Investing Daily

Human beings are creatures of chaos, which makes them predictably unpredictable. The thing about artificial intelligence (AI) is that it’s just that— artificial — and thus it is to a certain degree more predictable, observes Dr. Joe Duarte, editor of In the Money Options.


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Stock market participation via artificial intelligence seems to buy every dip. So, if the market’s recent history holds up, and the bots act as they have in the past, each market decline might be yet another opportunity to buy the dip and join the race to new highs in the major indexes.

What could possibly go wrong? How about everything? But Maybe Not Today.

This is not a natural state for the markets, or for the world. There are too many things that seem to be on their way to regrettable endings. “I have a bad feeling about this.” Thus at some point, the stock market is likely to have to revert to the mean as reality sets in.

That being said, this time may not be that time when traditional market rules return. Thus as traders we have to trade the trend. So if the new trend is up, we’ll trade up. And if it’s down, we’ll trade down.

At any rate there is no need to be in a huge hurry as once the robots pick a direction, they stick with it until the next textbook support or resistance level. That is the operating mode for now, until the bots change their tune.

Market Breadth Follows the Script

Machines are predictably programmed to trade based on simple technical indicators. And they always follow a very simple script, which in this case seems to have been that the New York Stock Exchange Advance Decline Line fall precipitously for a couple of days, only to find support at its 50-day moving average as it did in March.

Even more eerie, and machine like, are the nearly equal oversold readings on RSI and ROC from the March bottom and the current bottom if it holds.

chart 1

Over the last few months I’ve spent a lot of time analyzing the market’s moves, concluding that the machines are programmed to use the most basic technical indicators to execute trades.

These include the RSI and ROC — the former is a useful measure of the overbought or oversold status of the underlying asset, to execute while the latter measures the momentum of the current direction of prices.

And, lo and behold, as the New York advance decline line fell to its 50-day moving average last week and the RSI and the ROC nearly hit oversold territory. Then, just as in the Technical Analysis 101 textbook, the advance decline line bounced and the market followed.

S&P and Nasdaq Follow Same Script

It’s nice to know the robots are using a one size fits all script to trade the market. This is fairly obvious given the eerily similar chart for the S&P 500 and the Nasdaq 100 Index and their equally creepy mirroring of the NYSE Advance Decline line.

chart 2

Outside Fantasy Island: Real Damage inside the Smaller Stocks

It is quite plausible that we’ve seen the worst of the stock market over the next few weeks, if you use the Nasdaq 100 and the S&P 500 as your benchmark.

So if the robots do what they’ve done every other time since the November bottom and your investments are designed to mimic their performance, you’ll be o.k. until something changes to reverse the uptrend in these market indexes or the robot’s programs.

chart 3

But if you’re investing outside the robots' sweet spot you may be seeing something different. For example, as the big tech stocks have been making new highs, the S & P Midcap Index has fallen off the face of the earth.

This deep in the heart of the market index is very oversold now based on the ROC indicator showing a downward momentum washout.

But the Accumulation Distribution (ADI) and On Balance Volume (OBV) indicators are testing rising trend lines that go back to the November bottom, which means if these support levels are broken, the selling in this area of the market, in which there are more stocks that are getting all the robot’s money, is going to get worse. So like in a zombie movie, when the hands that come out of the ground start to grab the feet of the unsuspecting pilgrims trying to escape the holocaust, if there is no improvement in the smaller stocks, the odds favor the many pulling the few down.

What do I know?

I know. I might be over reacting. I may just be an old guy who doesn’t understand how this new world works. After all, I haven’t changed my iPhone in several years and I’m thinking of giving up cell phones altogether, which makes me one big ol’ square peg.

And although I’ve seen bulls and bears rise and fall, wars start, develop, and end, bubbles fill and explode, and all other types of major crises unfold, and still, through it all, I trade what we see.

So I’ll monitor the charts, trade in a vacuum, and follow the bots. They’ve got the money. And they’ve got the power. But I don’t trust them and neither should you. This is a dangerous game. Play at your own risk and understand what you’re doing and what you’re up against. All I can say is: “I have a bad feeling about this.”

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