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What is algorithmic trading and how does it work?

algorithmic trading2Algorithmic trading is an advanced form of automated trading, often employed by large hedge funds and investment banking firms. Most traders often mistake algorithmic trading to be similar to using an expert advisor.

An expert advisor is a type of trading script that buys and sells based on the trading logic that it is programmed to do. Algorithmic trading is somewhat similar to an EA. The difference being that algorithmic trading goes beyond a normal EA.

In technical jargon, algorithmic trading is also known as algo trading or back box trading. It is also known as high frequency trading. The basic premise of algorithmic trading is to take advantage of speed. Thus, a high frequency or an algo trading program enters and exits a trade in a matter of few seconds to make profits.

Profits with algo trading are made by taking advantage of speed. Therefore, most algo trading is done close to exchanges such as the NASDAQ or the New York Stock Exchange. Firms are known to invest lots of money to ensure that the latency is reduced and that they are able to be the first ones in and out of a position.

Algorithmic trading makes of speed and therefore is most prevalent during high impact news releases. Algo trading is also common in the futures and equity markets.

There are multiple uses of high frequency or algorithmic trading. For example, a hedge fund that wants to execute a large order can make use of high frequency or algorithmic trading to execute the trades in a way that it doesn't impact the overall price.


Strategies used in Algorithmic trading

Most algorithmic trading strategies are high end strategies. These strategies are developed by not one, but a team of experts known as quants. Strategies can be any of the following:

  • Momentum based algorithmic trading strategies
  • High impact news releases (interest rate or economic releases)
  • Sentiment based algorithmic trading
  • Text based algorithmic trading (Central bank statements, speeches, etc)

A quant, short for quantitative analyst build strategies to buy and sell. They make use of advanced match and statistical methods to come up with a sound algorithmic trading program. Most of the quants are employed in wall street and at major banks.

One of the advantages of using a quant is that they make use of multi-asset trading in order to diversify. Although algorithmic trading focuses mostly on a short-term trading strategy, using diversification and correlation, profits can be maximized.

Because of the immense potential of profits, most algo trading programs are a tightly guarded secret. One of the secrets to success with algorithmic trading is of course speed and access to information. Therefore, most of such programs also make use of market information.

Algorithmic trading strategies can be based on a number of concepts ranging from arbitrage models to regular indicator based models. You can also find algorithmic strategies that are based on seasonal patterns in the asset.


When algos go bad

While algorithmic trading is mostly used in positive terms in the profits they make, they can also be disastrous. One such example is the Knight Capital Group’s algorithm that almost bankrupted the company.

The company, Knight Capital group is a major market maker in the U.S. equity market. Just around the time their algorithmic program went rogue, the company made almost $1.4 billion in profits as a market maker.

Knight Capital Group was the market maker of choice for some big U.S. e-trading firms such as E*trade, Scott Trade and so on. In mid-2012, Knight Capital Group, KCG for short had a black swan event. In a mere 30 minute time frame, the company lost over $440 million thanks to its algorithm that went rogue.

This was three times the company’s annual earnings at that point in time. The losses left shareholders dumping the stock which fell over 75%. Eventually the company had to be bailed out by others from the Wall Street.

The KCG event shows the no matter how strong an algorithmic trading strategy is, risks are always around.

In the futures markets, it is estimated that over 70% of trading activity comes from algorithmic or high frequency trading.


Should you be concerned with algorithmic trading?

 

HFT trading across various assets

High Frequency or Algorithmic trading share (Source: Greenwich Associates)

 

Whether you are trading spot forex or futures, at some point you might have wondered if algorithmic trading is disastrous. Fortunately, the answer is no. There are a lot of misconceptions (such as the KCG event) that are often used to talk about the ills of algorithmic trading.

In an exchange based trading model, algorithmic trading programs can add immense value. An algorithmic trading program, because of its high number of orders adds a lot of liquidity to the market. This means that as an individual and a retail trader, you can get tighter spreads and better market conditions.

Most trades fall under the impression that algorithmic trading gives them an unfair advantage. However, the speed at which such trading programs are executed in fact adds to the volatility. For the average trader, profits are made when there is more volatility in the markets.

In conclusion, there is no denying the fact that algorithmic trading is the in-thing in the financial markets. With the advent of robo advisors and new forms of investing, algorithmic trading brings not just volatility but also liquidity to the markets.

For the average trader, this leads to tighter spreads and better market conditions.

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