ALGO TRADING

A trading system that utilizes very advanced mathematical models for making transaction decisions in the financial markets. The strict rules built into the model attempt to determine the optimal time for an order to be placed that will cause the least amount of impact on a stock's price. Large blocks of shares are usually purchased by dividing the large share block into smaller lots and allowing the complex algorithms to decide when the smaller blocks are to be purchased. The use of algorithmic trading is most commonly used by large institutional investors due to the large amount of shares they purchase every day. Complex algorithms allow these investors to obtain the best possible price without significantly affecting the stock's price and increasing purchasing costs. In electronic algorithmic trading or automated trading, also known as algo trading, black-box trading or robo trading, is the use of electronic platforms for entering trading orders with an algorithm deciding on aspects of the order such as the timing, price, or quantity of the order, or in many cases initiating the order without human intervention. Algorithmic trading is widely used by pension funds, mutual funds, and other buy side (investor driven) institutional traders, to divide large trades into several smaller trades in order to manage market impact, and risk.Sell side traders, such as market makers and some hedge funds, provide liquidity to the market, generating and executing orders automatically. A special class of algorithmic trading is "high-frequency trading" (HFT), in which computers make elaborate decisions to initiate orders based on information that is received electronically, before human traders are capable of processing the information they observe. This has resulted in a dramatic change of the market microstructure, particularly in the way liquidity is provided. Algorithmic trading may be used in any investment strategy, including market making, inter-market spreading, arbitrage, or pure speculation (including trend following). The investment decision and implementation may be augmented at any stage with algorithmic support or may operate completely automatically. A third of all European Union and United States stock trades in 2006 were driven by automatic programs, or algorithms, according to Boston-based financial services industry research and consulting firm Aite Group.As of 2009, HFT firms account for 73% of all US equity trading volume.

In 2006 at the London Stock Exchange, over 40% of all orders were entered by algo traders, with 60% predicted for 2007. American markets and European markets generally have a higher proportion of algo trades than other markets, and estimates for 2008 range as high as an 80% proportion in some markets. Foreign exchange markets also have active algo trading (about 25% of orders in 2006). Futures and options markets are considered to be fairly easily integrated into algorithmic trading,with about 20% of options volume expected to be computer-generated by 2010. Bond markets are moving toward more access to algorithmic traders. One of the main issues regarding HFT is the difficulty in determining just how profitable it is. A report released in August 2011 by the TABB Group, a financial services industry research firm, estimated that the top 10 Investment Banks around the world specialize in this type of trading took in roughly US$21 billion in profits in 2011. Algorithmic and HFT have been the subject of much public debate since the U.S. Securities and Exchange Commission and the Commodity Futures Trading Commission said they contributed to some of the volatility during the 2010 Flash Crash,when the Dow Jones Industrial Average suffered its second largest intraday point swing ever to that date, though prices quickly recovered. (See List of largest daily changes in the Dow Jones Industrial Average.) A July, 2011 report by the International Organization of Securities Commissions (IOSCO), an international body of securities regulators, concluded that while "algorithms and HFT technology have been used by market participants to manage their trading and risk, their usage was also clearly a contributing factor in the flash crash event of May 6, 2010.

Whos Leading the Charge ?

According to the Tabb Group report for 2011-2012 , Credit Suisse, Goldman Sachs, Morgan Stanley, Nomura Holdings Inc and Investment Technology Group are the pioneers in the field. They have captured the most desktop real estate and clients. Other firms that are aggressively pushing their solutions include Citigroup, Bank of New York Mellon, JPMorgan Chase, Merrill Lynch and Barclays. Other sources include buy-side quantitative analysts that create their own algorithms and third-party vendors like FlexTrade Systems, Progress Software and Portware, which offer canned algorithms and tools to develop customized algorithms.

Algorithms Migrating to Currencies

The use of algorithms in multiple asset classes will continue to increase. There are strong indications to date that algorithms also have a place in the $2 trillion-plus global foreign exchange market, at a time when investors are incorporating foreign exchange (FX) into multi-asset-class strategies. Market participants have long recognized that established equity trading techniques such as baskets and order slicing apply to FX. They are quickly finding out that in the fast-moving FX markets, algorithmic trading is even more effective. It is a fact that algorithms in FX markets are still at an early stage relative to the equities markets.

Fixed Income Next

The introduction of algorithmic trading is being explored in the fixed-income market. It is happening slower than in foreign exchange. The reason for the slow uptake is due to a different market structure in terms of how it functions and operates and algorithmic trading takes off fastest where there is an order-driven environment and greater price transparency. Once European markets embrace the Markets in Financial Instruments Directive

(MiFID) algorithmic trading across fixed-income markets gets a boost to take off. MiFID promises to be catalyst, by encouraging a move away from dealer-led markets to central order-driven pools of liquidity.

Conclusion

Algorithms are widely recognized as one of the fastest moving bandwagons in the capital markets. Employing rules-based strategies has enabled buy-side firms to increase productivity, lower commission costs and reduce implementation shortfall. Algorithmic trading cuts down transaction costs and allows investment managers to take control of their own trading processes. By breaking large orders into smaller chunks, buy-side institutions are able to disguise their orders and participate in a stocks trading volume across an entire day or for a few hours. More sophisticated algorithms allow buy-side firms to fine-tune the trading parameters in terms of start time, end time, and aggressiveness. In todays hyper-competitive, cost-conscious trading environment, being the first to innovate can give a broker a significant advantage over the competition both in capturing the order flow of early adopters and building a reputation as a thought leader.