What is Algorithmic Trading?
Algorithmic trading is a type of trading that uses complex mathematical and statistical formulas to make decisions for each trade. An algorithm is a set of directions for solving a problem. An example of an algorithm is an algebraic equation, combined with the formal rules of algebra. With these two elements, a computer can derive the answer to that equation every time.
Algorithmic trading is a method of executing trading orders using automated pre-programmed trading instructions accounting for variables such as time, price, and volume. They were developed so that traders do not need to constantly watch a stock and repeatedly send those slices out manually. Popular “algos” include Percentage of Volume, Pegged, VWAP, TWAP, Implementation Shortfall, Target Close.
In the twenty-first century, algorithmic trading has been gaining traction with both retail and institutional traders.
Algorithmic trading is not an attempt to make a trading profit. It is simply a way to minimize the cost, market impact and risk in execution of an order. It is widely used by investment banks, pension funds, mutual funds, and hedge funds.
Advantages and Disadvantages of Algorithmic Trading
Algorithmic trading is mainly used by institutional investors and big brokerage houses to cut down on costs associated with trading.
According to Henry Yegerman's research, algorithmic trading is especially beneficial for large order sizes that may comprise as much as 10% of overall trading volume. Typically market makers use algorithmic trades to create liquidity.
Algorithmic trading also allows for faster and easier execution of orders, making it attractive for exchanges. In turn, this means that traders and investors can quickly book profits off small changes in price.
The speed of order execution, an advantage in ordinary circumstances, can become a problem when several orders are executed simultaneously without human intervention. The flash crash of 2010 has been blamed on algorithmic trading.
Another disadvantage of algorithmic trades is that liquidity, which is created through rapid buy and sell orders, can disappear in a moment, eliminating the change for traders to profit off price changes. It can also lead to instant loss of liquidity.