Algorithmic trading is the use of mathematical formulas to produce trade signals or handle order flow. It started in the 1980’s where computers bought and sold baskets of stocks based off the premiums found in the futures markets. Over the years it became more popular due to changes in market structure and technological advancement. Nowadays it is used by both institutions and non-institutions, to handle order flow of larger orders and to provide trading signals for firms.
It is not uncommon today for an institution to use algorithms to handle block trades for the firm. By using algorithms firms can decrease their costs by utilizing less man power to perform the same number of executions. These algorithms can also trade faster. Therefore they are able to break large orders into smaller ones and execute them faster than a human being. By breaking up the orders firm can lessen their market impact and increase their chances of getting the best market price. Many of these types of trades are based on how close their average price is relative to the VWAP of an equity.
Another use for algorithms is to provide trading signals for a firm ranging from intraday signals all the way to weekly and monthly. By using complex formulas developed in house, firms can best position themselves for what they feel will be the future movement of the markets. These types of algorithms tend to be found more on the non-institution side, using strategies such as:
- Trend Following
- Pair Trading
- Delta Neutral
- Arbitrage
- Mean Reversion
- Scalping
One of the more recent and controversial uses of algorithms is in high frequency trading. This evolvement of algorithms has relied most on the advancement of technology. These types of traders are more dependent on latency than anything else. Latency is the time it takes for a packet of information to make a round trip from destination to destination. Many of these traders claim to perform market maker duties by providing various stocks with liquidity. However, they are not held to market maker regulations. High frequency traders have also been blamed to be predatory by probing the market for block trades and jumping in front of the orders. Much is still unknown about the exact effect these traders have on the market.
