Algo trading and what it means to you :: Business Line

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Algorithms may shrink opportunities for day-traders and increase stock price swings. But some of them can actually help long-term investors buy and sell more efficiently.

Giant computers spit out buy and sell orders every milli-second. Tech-savvy traders direct them with complex formulae. And institutional investors rake in the money, while the retail investor watches helplessly from the sidelines. If that is the image that ‘algo trading' conveys to the layman, it may not be wholly accurate.

Yes, programmed trading does pose certain risks to the market. Studies find that it can increase volatility in stock prices. Erroneous trades, if allowed to run on unchecked, can distort prices and create risks to the market itself.

High-speed trading may also whittle down opportunities for day-traders, arbitrageurs and jobbers who rely on old-fashioned manual methods to pocket quick gains.

But there could be positive spinoffs from automated trading too. For instance, as basic algos become more accessible, retail investors and mutual funds (which deploy retail money) may secure better prices when they execute trades.

Algos (of the right kind) may also help iron out the many instances of inefficiency and mispricing in the Indian market, by rapidly closing in on arbitrage opportunities.

Finally, algo trading may not impact you much, if you are investing in stocks for a 5 or 10-year period. In fact, for long-term investors, the higher liquidity could mean better opportunities to buy or sell stocks at times of their choosing.

WHAT'S AN ALGO?

Before we go into all that though, what is algo trading? Short for algorithmic trading, algo trading is simply the use of computer programs to execute trades in the stock, commodity or other financial markets.

Algo trades are automatically triggered by computers programmed to kick into action if certain market conditions are met.

These conditions are decided by the underlying code or algorithm. Broadly, algorithms fall into two categories (See article below). Those that help the trader execute transactions at a better price and those that actively generate returns by cashing in on market anomalies or trends.

High Frequency Trading or HFT is a form of automated trading which cashes in on fleeting market opportunities through a deluge of orders executed in fractions of a second. Positions may be held only for minutes, the ‘portfolio' is churned furiously and no position is carried overnight!

Given that they are chasing minuscule gains from high volumes, high-speed traders gain by shortening their execution time to a few milli-seconds.

Stock exchanges around the world (and in India too) have actively aided and abetted HFT by allowing market players to rent ‘co-location' facilities at the exchange itself.

With their terminals huddled close to the exchange's servers, co-located members — through fibre optic connectivity — execute trades at a fraction of the time that others do.

GETTING BIGGER

So how big is algo trading (including HFT) in India? Quite significant, suggests data.

Recent disclosures from the National Stock Exchange (NSE) show that about 16-17 per cent of the monthly trading in the equity segment (cash and futures) now originate from algo trades.

Another 14-15 per cent of trades, handled by co-location facilities are likely to be high-speed too. Roughly 30 per cent of trading in the Indian equity market therefore, could be algo-based. This makes it imperative for investors to take note of the trend.

WHAT IT MEANS FOR YOU

So what does algo trading mean for investors, particularly of the retail variety?

For one, it makes life very difficult for day traders. Algo trading (and its cousin HFT) can substantially aggravate intra-day volatility in a stock. Trend-following algos, for instance, ride the momentum in a stock or an index, causing sizeable swings in its price within minutes. This can decimate the unprepared day trader.

Two, with computer programs constantly on the hunt for money-making opportunities, manual traders may be edged out of such trades.

For instance, if a trader routinely makes money by shorting the Infosys stock after every disappointing result, algos may shut this window of opportunity by issuing a deluge of ‘sell' orders much before a human trader possibly can. Institutions with deep pockets are also likely to have an undeniable edge over the small guy.

Defenders of algo trading, however, argue that there was never a level playing field to start with. Investors with hi-speed Internet connections, for instance, already score over those with dial-up connections.

Three, given that automated trades and HFTs pump large volumes of trades into the market, an erroneous algorithm can wreak quite a bit of havoc on the market itself.

It was unchecked, erroneous algo trades from a single broker that gave rise to wild swings in the Sensex Futures in the Muhurat trading session. The exchange stepped in, post facto, to cancel the entire session. And US regulators are still examining if it was HFTs which caused US bluechips to trade at ridiculously low or high values during the Flash Crash of May 2010.

A final concern about the rising clout of algo trading is whether all this focus on short-term gains will make the entire market less focussed on fundamentals.

PROTECT YOURSELF

But in the capital markets, it is extremely hard to stop the onward march of an idea whose time has come. So what can retail investors do, to deal with the risks from algo trading?

To start with, they must take note that punting on the market for intra-day gains has become way too risky.

If wealth creation over the long term is really your objective, it seems best to stick to investment vehicles such as mutual funds which can use algos to their benefit.

But if you must invest directly in the markets, you could use a few checks and balances (see graphic) to contain the impact of unexpected market volatility on your purchases.

Finally, if you can't beat them, you can certainly join them. One good thing about technology is that older advances in it quickly become commoditised and accessible to all.

Retail investors even in India already enjoy access to the basic algo trading tools. The NSE trading platform incorporates execution algos such as the VWAP or TWAP. To secure better prices for your trades, all you need to do is to ask your broker to use them on your behalf.