From data processing to automated reasoning, computer software can do it all, and with unmatched speed and accuracy. It’s only logical, therefore, that they are also used for trading on the stock markets. Algorithmic or automated trading refers to using a computer program that automatically submits trades to an exchange without any human intervention.
In India, algorithmic or algo trading is popular among institutional investors like investment banks and hedge funds, and accounts for 35-40% of the turnover on the exchanges. It is usually carried out using software provided by a brokerage firm of a third-party provider. For retail investors, algo trading can be prohibitively expensive since it involves setting up a separate server.
What is it?
An algorithm is a set of instructions which a computer is programmed to follow in order to carry out a particular task. In the case of trading, these defined instructions pertain to placing trades with a speed and precision which a human trader would not be able to achieve. The instructions set the timing, quantity, price limits or any other relevant criteria that would ensure the most profitable trade.
Automated trading takes the unpredictability of human emotion and impulses out of trading by eliminating human intervention altogether.
Algo trading is mostly used for high-frequency trading (HFT), which involves placing a large number of trade orders across multiple markets and decision parameters at a very high speed, based on preprogrammed instructions. This expands market reach and increases the possibility of making a profit.
Algo trading has been under scrutiny for some time now because a probe by the Securities and Exchange Board of India (Sebi) earlier this year into NSE’s algorithmic trading platform found that some traders had unfair access to market data and trading systems. Since then, the regulator has strengthened the framework for algo trading.
Does it affect you?
This type of trading is more popular among institutional investors across the world than retail investors. The technology required to carry out this form of trading is not easily accessible to small-time investors. But even if retail investors don’t participate in algo trading, they might feel the impact of HFT. In the time that it takes for an investor to execute a buy or sell order, an HFT system can execute multiple trades and benefit from the final price entered by the investor. This also increases market volatility since even a small fall in the market can trigger a mass sell order, leading to a crash.
At present, there are no defined rules regarding algo trading for retail investors. However, some brokerage firms offer it as a product. Last year, it was reported that Sebi is likely to put out guidelines for algo trading for retail investors. However, there were no further follow-on reports.
It is important to keep in mind that algo trading is a market strategy and not meant for long-term investors.