What is Algorithmic Trading?
What is Algorithm? And what is Trading?
To understand Algorithmic trading we first need to understand what is an Algorithm. Algorithm is a specified and predefined set of instructions that are formulated and fed into the computer system to carry out the desired activity aiming at a specified outcome. Trading means buying and selling of securities.
Algo trading can alternatively be also termed as automated trading system. Algorithmic trading is a process of placing an order of large size which gets executed with the help of trading instructions set by a software program which takes into consideration variables like – time, price, news dissemination and capacity or volume. The widely known “algos” comprise variables like “percentage of volume”, “pegged “, “Volume Weighted Average Price”, “Time Weighted Average Price”, “ implementation shortfall”, “Target Close”. On the basis of these parameters they can send small bits of the bulk order over a specific span of time to the market. This entire system is automated and does not require constant monitoring of the market and the positions of the concerned stocks in the portfolio. Additionally there is no requirement of manually sending out orders to the market in piece meal basis.
High-frequency trading (HFT)
High-frequency trading (HFT) is one kind of algorithmic trading which include high speeds, high order-to-trade ratios (No of orders placed in the trading system to the No. of trades executed and matched in the trading system), high-frequency, sophisticated algorithms, co-location (Stock brokers can co-locate their ALGO IT infrastructure at the exchange premise which is closer to the exchange servers used for trade matching) and very short-term investment horizons.
If we see a few years back, the concept of algo trading had started gaining momentum from both retail traders and institutional traders. The popular medium for algo trading are- MetaTrader, NinjaTrader, IQBroker, and Quantopian.
Algorithmic trading has been developed with the aim not only to make the profitable trading but with the intention to curb on the cost component, to minimize the market impact and to minimize the risk that is involved in execution of an order. The system is very popular amongst banks, pension funds, mutual funds and hedge funds.
Algorithmic trading, often referred as black box trading, the system largely depends on critical mathematical calculations based on formulae and very efficient computer programs that are tuned to calculate and crunch such complex numbers. Some strategies that the Algo traders use are pairs trading, Arbitrage, scalping and Trading ahead of index fund re-balancing.
In simple words we can conclude that Algorithmic trading is the means to utilize computer based programs to undergo and follow a pre-defined set of manual of instructions for carrying out a trading activity in order to churn out profits with the speed, accuracy and proficiency that is not merely possible and feasible for human traders to perform. The biggest advantage of Algo trading is that it makes the market very easy and flexible to comprehend, renders a practical approach by avoiding emotional and biased impacts on the trading decisions, it is an objective method that is being followed.