What is algorithmic trading?
Simply put, algorithmic trading refers to the use of automation for trading in financial markets. This entails execution of a trading strategy using a computer programme (algorithm).
Earlier, these strategies were executed by humans. Use of automation removes human emotion element in trading. Algorithms are used for speedy execution of trades, faster identification of arbitrage opportunities, strategies seeking to beat return benchmarks (alpha seeking) and high frequency algorithms.
What is the confusion?
Algo trading has often been used inter-changeably with high frequency trading which is a form of algo trading, leading to confusion.
In high frequency trading (HFT), algorithms are used to interpret market signals and patterns and trades are executed and reversed within a fraction of a second, multiple times during the trading session to generate profits. Volumes are huge and the spreads fine. Hence, the HFT algorithms target the most liquid segments of the market.
Speed of execution is top priority and HFT makes use of direct electronic access to markets and co-location of servers to reduce time taken to execute transactions.
How is an algo created?
The first step in the creation of an algorithm is the presence of a trading strategy. This trading strategy is then converted into a computer programme (algo) with the help of a software expert who programmes this strategy in a high-level computer language using the requisite parameters.
The programme thus created is back tested using historical data from the stock exchanges for efficacy. After an entity commences live trading using algorithms, it takes a few weeks to stabilise the algo. Brokers offering algo trading services have to take prior approval from stock exchanges.
How is an algorithm different from human intervention?
Every algo has two parts to it. The first is the identification of a buying or selling opportunity which entails what to buy or sell (asset class- debt, equity, currency, commodity) and when to buy or sell.
The second is the execution logic which defines how the trade will be executed. That is, what would be the type of order that would be punched; at what levels would profits or losses be booked; what would be the stop-loss and at what price the stop-loss would be triggered and executed finally; and whether the orders would be sliced on entry or exit.
How are algo orders routed?
The algo trades are routed to the exchange through the broker’s application. The broker’s application consists of a data centre, order routing system, order management system and a risk management system.