Algos at work :: Business Line

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Why is algo trading such a hit? And how do these programs actually make money?

Though new money-spinning codes are being written every minute, the basic algos can be classified under two categories.

EXECUTION ALGOS

These programs execute your stock market trades in such a manner that the prices that you secure aren't influenced by momentary swings in the market.

Two of the common execution algos are the Volume Weighted Average Price (VWAP) and Time Weighted Average Price (TWAP).

The VWAP is calculated by weighting a stock's price quotes through the trading session with volumes traded at each price. The algo's objective is to execute the order at a price that is as close as possible to this weighted average.

Why use this strategy? Well, the TCS scrip traded in a range of Rs 1,093 to Rs 1,107 this Thursday. Its VWAP was Rs 1,103. An investor selling the stock at the VWAP instead of at the day's low, would have gained as much as Rs 10 per share.

Institutional investors such as mutual funds and pension funds, which measure their returns based on end-of-day prices, may also use the VWAP for the last 30 minutes to buy or sell their holdings to reduce deviations.

The TWAP strategy simply breaks up a large order into equal parts and then dribbles buy or sell orders into the market evenly over the trading session. This ensures that the price at which the investor buys or sells is not distorted by momentary blips in the market. Using a TWAP is much like using a mutual fund systematic investment plan (SIP) — only compressed into minutes rather than months.

ALPHA-GENERATING ALGOS

Unlike execution algos, alpha-seeking algos actively try to make money. They track historical relationships between securities, assets or markets and then exploit minor deviations for quick gains.

Some of the common ones are:

Arbitrage algos: Much like the traditional arbitrageurs do, these algos earn a spread from trading on anomalies between securities, trading venues or asset classes. A simple arbitrage algo may earn a ‘spread' by buying Reliance Industries at Rs 745 on the BSE and selling it at Rs 745.50 on the NSE. Arbitrage profits can also be earned by exploiting differentials between futures and cash markets.

A variation is the ‘event' arbitrage, which exploits money-making opportunities arising from mergers, buyouts or restructuring. An algo trader, alerted instantly to an acquisition, could buy the acquirer's stock and short the target's.

Trend following algos: Trend-following algos follow the simple maxim – the trend is your friend. They employ techniques commonly used by technical analysts to identify a reversal in trends. They then piggyback on it at an early stage to benefit from the momentum.

These algos may track technical indicators such as the 50 or 200-day moving averages or relative strength index, to bet on stocks on the verge of breaking out or breaking down.

These alpha-generating algos seem to be the more commonly employed ones in the Indian market. Needless to say, these strategies may work only in liquid instruments. These, say market participants, are restricted to the top 30 stocks by market capitalisation or to the more actively traded Nifty future and option contracts.