Before I begin – Remember that while algorithms can enable high frequency trading, the scope for algorithmic trading is much wider. While all high frequency trading will use some form of computer programming, all algorithms are not written to execute only high frequency trades.
Every buy/sell trade in the stock market is backed by a ‘Decision’, followed by ‘Execution of Trade’. Modern technology has allowed the second leg of this process, i.e. – execution of trade to be automated by the use of sophisticated computer based mathematical combinations – Algorithms.
Investopedia defines ‘Algorithmic trading as “a trading system that utilizes very advanced mathematical models for making transaction decisions in the financial markets”. Using algos, you can place a buy or sell order of a defined quantity into a mathematical model that automatically generates the timing of orders and the size of orders based on goals/parameters specified by the trader.
Simply put, algorithmic trading refers to orders generated by the use of advanced mathematical models that will automatically execute the trade. The need for human intervention is minimal and decision making is quick. This also helps in increasing the number of simultaneous trades which will not be possible manually. Further, trades are executed by a computer with no human errors and are free from the influence of human emotions in decision making.
How is an Algorithmic Trading System Created?
Of course, for algos to start working, a human will first have to write a code for the ‘Execution of trade’ on the basis of certain pre-defined conditions.
To explain how an algo may actually be written, consider this – a trader observes that each time ITC stock begins to decline, Infosys stock starts falling soon after. The two events happen within microseconds from each other. This could be because (may be) when a big mutual fund baskets sells its units, the order in which the trades get executed at the exchange level is – first, ITC stocks are matched and sold, this is followed by Infosys and then other stocks in the mutual fund.
Many such short term patterns may develop. In the above example, the algorithm is written in such a way that the moment, ITC stock falls by more than X% (signaling a big mutual fund sale), the computer sells Infosys stock which is now also likely to go down. Algorithms could well be used for stocks declining or rising, for futures, options or in any other market with only one pre-condition – there must be high volume in the underlying security.
NOTE: What is discussed above is just one such pattern and may be an over simplistic explanation. In reality many combinations could be fed into the algorithm making it a very complex trade.
Based on your observation, the trading strategy which you think works is converted into a computer program. This is done with the help of software professionals who programs this strategy using high-level computer language.
- Buy 50 shares of ITC when its goes below 325 and when Reliance is up by 10%.
- Sell 50 shares of ITC when its goes above 375 and Reliance is down by 10 %.
Using this set of two simple instructions, a computer program will automatically monitor the stock prices of ITC and Reliance and will place the buy and sell orders when the defined conditions are met. It is no longer required to keep a watch on live prices, charts, graphs or put in the orders manually. The algorithmic trading system will automatically do it for the trader, by quickly identifying the opportunity.
Thousands of algos could be written to buy or sell a security, currency or commodity at a specific level and when one or more condition is satisfied. For example, an instruction could be to sell the future of Reliance and buy the stock if the futures price is 10 % higher than the stock price. Also, it could be to compare a set of variables – if the rupee is more than Rs 62 to a dollar and crude oil is more than USD 135 per barrel, sell 500 shares of Cairn India at the same time.
Algorithmic Trading to Capture Arbitrage Opportunities
Consider a world without algorithmic trading where all arbitrage opportunities are captured manually. To make profits from potential difference in prices, arbitrageurs would use 2 computers, manually entering buy order on one and sell order on another, or waste the precious 1-2 seconds before punching buy and sell orders one after the other. Speed would be the biggest skill here. A slight error on keyboard like pressing F2 instead of F1 can result in a large loss. In fact, have we not seen flash crashes before?
You could eliminate much of these things by using a technology to do exactly the same thing. Algorithms can be created to calculate and identify arbitrage opportunities across multiple segments, multiple expiries (near vs. far) or multiple instruments (futures vs. options).
Due to the automation of trading strategies, trades are quickly executed – think microseconds and are expected to move to nanoseconds with more technological advancement. So the execution of algorithms set by traders plays an important role in identifying opportunities before other market participants. Algorithmic trading helps in identifying opportunities in all market situations whether there is an uptrend, downtrend or even in a range-bound market.
Benefits of Algorithmic trading
- Execution of trades at the best possible price
- Timely trades
- Reduced risk of manual errors in placing orders
- Reduced human errors based on emotional and psychological factors
- Trade multiple accounts or various strategies at one time
Guidelines on Algorithmic Trading
After witnessing a growing trend of using advanced technology for trading in stock market, SEBI issued its first guidelines on algorithmic trading in March, 2012. As per SEBI guidelines:
- All stock brokers and traders using algorithmic trading software will have to get approvals from stock exchanges (BSE/NSE).
- The stock exchange may seek details of trading strategies used by the algo for inquiry, surveillance, investigation purposes.
- To ensure compliance with the requirements prescribed by SEBI and the stock exchanges, every six months audit of algorithmic trading system is mandatory.
- Algo orders shall not be released in breach of the price bands, quantity limit and value per order defined by the exchange for the security.
Algorithm trading is widely recognized as one of the fastest emerging technology in the capital markets. Employing rule based strategies has enabled traders to increase productivity and reduce implementation shortfall. Algorithmic trading cuts down transaction costs and allows traders to take control of their own trading processes. More sophisticated algorithms allow traders to fine-tune the trading parameters in terms of start and end time, and aggressiveness. In today’s competitive, cost-conscious trading environment, being the first to innovate a trading strategy can give a broker a significant advantage over others. In the more developed economies like the United States and Europe, there is a full-fledged technology war 80-90% of total trades being executed using algorithms. India is not far behind.
My personal view – If any broker/ trader or money-manager tries to tell you that he trades options or futures, earns arbitrage/ price difference etc. Just Run!
The market for this sits close to the exchange terminals; in fact they are co-located i.e. based inside the NSE / BSE buildings to get that microsecond advantage to execute faster trades. In fact if you are trying to trade based on any skill or scheme of yours – Stop. No matter what you do, you are never going to beat a computer when it comes to spotting market opportunities.