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Network Effects on Trading

In class we have generally viewed networks effects in situations concerning markets and how people act in markets. It is important to realize that the concept of network effects can be taken to any situation where people are part of the fundamental basis in making decisions and choices. This article demonstrates how we can apply network effects to the trading of stocks. We start by discussing the field of technology. In technology, there are many positive externalities that occur due to the advent of network effects. Why has this been brought up? Network effects are demonstrating their influence on topics such as open-source technology that affects all that are involved in such projects. It is fairly simple to understand that “positive network effects occur in products which get more valuable as they attract more users”. A simple scenario to illustrate this is seen in the creation of social networks. When more people use a social network, they gain more value out of being a part of the network. We can transpose this to the situation of trading stocks.

In old school trading, the trading pits had to be utilized in order to gain information and complete transactions. What made these pits so valuable? The traders within the pit always had the best information due to the sheer number of people that utilized that information. As the article concludes in this situation, “Thus, the more people who traded on the floor, the more valuable the pit became to each individual trader”. However, the advent of electronic trading rendered these pits obsolete, and for exact reason why the pits were successful. Those that utilized electronic trading were able to implement trading strategies that were able to exhibit network effects that allowed traders to make strong returns. For example, the article poses a scenario where we take two stocks and treat them as a tradable pair in two controlled situations. One situation was when the trader made the relation himself while in the second case the trader was part of the community of traders. If the two stocks do not demonstrate dependency, the first case would be unstable and force the trader to bail out. However, in the second case, the number of traders in the community and their confidence on long-run equilibrium would keep them bent on that relation, hoping that it is only a temporary deviation.

These network effects can result in either a positive or negative return. For all we know, the community of traders have been affected by an information cascade that blinds them from taking an analytical decision and bailing out of the trade. It is important to understand as we saw from class that network effects do indeed work in increasing popularity, but it doesn’t indicate whether decisions/choices were right. We have gone through class learning about how the concept of marketing and advertising works in terms of network effects. We also learned about information cascades and how we make decisions based on only a few pieces of data. It is important to realize however, that one cannot simply make decisions based on network effects – some actual analysis must be done as well. In the fields of trading and technology, network effects may give us insight into trends that we have to evaluate ourselves. Choosing to simply follow the trends may be detrimental for those in these networks, which in the large scale of the world economy could affect us all. Continuing to utilize network effects is important in order to provide more value for each person who joins the network and stays a part of the network, leading to benefits for both the individual and the community, if done right.


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November 2015