ALGO_TRADING
As many of us
are aware, trading is done either by Individuals as ‘self’ or through broker
agents or by equity advisors of a broking firm. Similar in these lines we have
another type of trading called Bulk trading or block-trading or black-box
trading that is often done only by some of the broking firms especially in US,
UK and European countries. Usually this type of trading is also referred to as
High-frequency trading (HFT) especially in India which deals with trading done
in huge quantities or at a large scale. The high-frequency trading strategy was
first initiated by a company called Renaissance Technologies, USA. The other
major high-frequency trading firms in USA include Chicago Trading, Virtu
Financial, Timber Hill, ATD, GETCO, Tradebot and Citadel LLC.
Investopedia
defines HFT as “High-frequency trading is a program trading platform that
uses powerful computers to transact a large number of orders at very fast
speeds using complex algorithms
to analyze multiple markets and execute orders based on market conditions.
Typically, the traders with the fastest execution speeds will be more profitable than traders with
slower execution speeds”. Computerized trading is used primarily by institutional investors
typically for large-volume trades. Orders from the trader's computer are
entered directly into the market's computer system and executed automatically.
This type of trading involves
trading strategies based on algorithms or complex mathematical formulae, which
is carried out by computers to move in and out of heavy or large positions in
seconds or fractions of a second. The algorithms are closely guarded and
executed by their owners (broking firms) and are known as "algos"
hence this type of trading is referred as Algo-trading (Algorithmic trading). Analgorithm is a specific set of
clearly defined instructions aimed to carry out a task or process. The
algorithm one company uses is not similar to the algorithm used by another
company hence the effective ones churns out the best returns/profits out of
their investments.
Algorithmic trading is a process that uses
computer programming which follow a defined set of instructions while placing a
trade in order to generate profits at a certain speed and certain frequency
that is impossible for a human trader. These defined set of rules are based on
timing, price, quantity or any mathematical model based on either simple or
complex strategy it involves as per requirements of a broking firm. Apart from
profit opportunities for the trader, algo-trading makes markets more liquid and
makes trading more systematic by ruling out emotional human impacts on trading
activities.Algorithmic
trading is widely used by investment banks, mutual funds, and other
institutional traders, to divide large trades into several smaller trades to
manage market impact and risk. Algorithmic trading is
appealing to buy-side firms because they can measure their trading results
against industry-standard benchmarks such as volume weighted average price
(VWAP) or the S&P 500 and Russell 3000 indices in US.
Algorithmic trading volumes are also
currently driven by sell-side proprietary traders and quantitative hedge funds
which thrive with a never ending quest to
please their high end customers in order to acquire great deals from them. Such
traders continuously work on ways and means to attract their customers with
their innovative and die-hard spirit. The first to innovate broker gets a
significant advantage over the others in such competition, in both ways of
capturing large orders and a reputation of being a innovative thought leader.
This scenario is possible only when best algorithm is put in place to enjoy a
significant time window ahead of the competition if that algorithm addresses a
really unique execution strategy.
HFT firms do not consume significant
amounts of capital, accumulate positions or hold their portfolios
overnight.These HFT firms make up low margins with incredibly high volumes of
trades usually in millions.As a result, HFT has greater and higher risk than
traditional buy-and-hold strategies have. A High-frequency trader usually competes
against other HFT, and not on long-term investors. Members of the financial
industry generally claim that high-frequency trading substantially improves
market liquidity, lowers volatility and makes trading and investing cheaper for
other market participants.
On the flip side, research body
argues that HFT and electronic trading pose new types of challenges to the
financial system and the trading discipline which is very much grounded in the
market since decades.Several European countries have proposals to ban HFT due
to concerns about volatility which is experienced sometimes with sharp spikes.
High-frequency trading has been the subject of intense public focus and debate
since the May 6, 2010 Flash Crash. Regulators claim that these practices only
contributed to volatility in the May 6, 2010 Flash Crash and found that risk
controls are much less rigorous for faster trades. Nobel Prize–winning
economist, Michael Spence, believes that HFT should be banned keeping healthy
trading and long term perspective in mind.
In India, the debate over the use of
HFT has resurfaced after the recent release of Michael Lewis' book Flash Boys, which is critical of the
system. The discussion within SEBI is that stock exchanges should implement its
guidelines which statethat there should be a two-queue system for orders coming
from co-location and other mode. Such architecture will provide orders
generated from a space not co-located. This way there is a fair chance of
execution and also addresses the concerns related to being crowded-out by
orders placed from co-location, a SEBI official said. Co-location is like
proximity hosting, where the exchange hosts the subscriber's server at its data
center i.e near the master trading engine and helps in faster movement of data
and execution of trades. Not all traders can use co-location as setting up the
infrastructure as it involves huge costs.
In India, both National Stock
Exchange (NSE) and the BSE do not follow any separate queue system currently.
If implemented, this two-queue system would ensure stockbrokers who are not
co-located to have a fair and equitable access to the stock exchange's trading
systems, said SEBI. The regulator had said distribution ratio of orders from
terminals/servers that are not co-located to the orders from co-located servers
may be kept at 1:1 and, in future, it may be reviewed based on the feedback
from market participants.As per the latest data on NSE, HFT constitutes 17.15
per cent of the overall trading volumes. HF proponents say "SEBI's suggestion
cannot be implemented as Co-location is mainly for time priority. It gives
liquidity to markets with high number of passive orders. If orders that come
first may not go first, then people will stop using it. Separate order queues
will close down co-location".Only time will tell the future and
implementation of Algo trading but without strict compliance and guidelines it
would be calling in for a financial disaster if
implemented in India.
-
Ms. E. Madhavi
PhD Scholar, GIM.