The Understanding of Algorithmic Trading From a Laymen Perspective

In an urban world when performing a simple calculation at the grocery store of $13.67 + $23.78, we rely on the billing machine.It’s hard to expect a fund manager or a buy-side trader to put a formula and come up with a statistics of profitable trade. We rely on them, and they rely on of complex algorithms stressing a cost conscious and hyper-competitive trading environment. Algorithms are now the part and parcel of any trading platform, and brokers extensively use them to poach new clients and retain their loyal customers.

Trades captured with the use of algorithm are known as Algorithmic Trading. In more technical words — In Algorithmic Trading a trader places a buy or sells order to a qualitative model which already has a set of constraints and parameters, and that generates the timing and size of order to be captured. The model has a defined set of protocols, and its goal is to generate precisely the timing and size of the order execution that causes least amount of collision on the financial instrument under scrutiny.

Algorithmic Trading is nothing more than automation of a trader’s execution strategy. Generating programs and coding the strategy reduces the TCA and is beneficial for fund managers as they could take the control of their trading processes.

All the buy side firms, find the algorithmic trading a charmer. Well, if you could slice a 1,00,000 shares order, and feed it to the market incrementally for a fixed period. And the period variations is something as chosen by the traders strategy of aggressiveness, start and end time with constraints like order price, size, order type, volatility, and liquidity. And the beauty of the whole of this could be achieved in a single click, the buy-side firms would find it hard to resist. The automated trading also gives an extra advantage to buy side firms by allowing them to measure their trading performance against industry set standards like S&P 500, VWAP [Volume Weighted Average Price] and Russell 3000 indices.

The Sell-side, however, are benefitting by adopting the best and unique execution strategy and pleasing the customers. As some profit earned for the customer could double or quadruple their sales and business. So innovation and research could help the sell side firms in implementing the execution strategy and stay ahead of their competition.

Algorithms could be used at all stages of a trade lifecycle. Mostly, we can classify them into these three core areas –

  • Pre-Trade Analytics — Pre-Trade Analytics is a study of historical data, current price and volume of the order, and then traders could suggest precisely the time and volume of order to be sent for execution. It also helps in suggesting whether the order should be traded manually or with the use of specific strategy via algorithms. With the help of algorithms, buy-side firm provide a benefit to their prestigious client by controlling the aggressiveness and could visualize the completion and impact on the market. Many of the brokers sponsored algorithms available in the market, also help to measure the TCA of a trade, helping the client to save the hard earned money.
  • Trade Execution — At this stage, algorithms helps a trader by selecting a list of stocks, specific strategies such as TWAP and enters start and end time. Viewing the progress in real time, they could also change the parameters, adding or deleting to gain the maximum benefit in the market.
  • Post-Trade Analytics- Post Trade Analytics aids in keeping a tab on commissions and the charges applicable from when the order was initiated till its completion i.e. execution. The post trade analysis helps to check how the trade performed and what the missing factors were if the execution was not as per the expectation. The trades once executed are measured across industry standards to benchmark the performance of a stock and check on the quality of execution.

If your question is — whether you could make a guaranteed profit of $X every month using algorithmic trading?

The answer is No. A guaranteed success or profit is not possible, as the market conditions change every moment.And no algorithm is so powerful and have a set of all constraints and parameters that could provide you with a foolproof solution.

To all the buy side firms who are selling you the fastest execution rate because of algorithmic trading, or because you can moderate your aggressiveness in the market. Just hold on, and let’s take a look at the areas that lack transparency in algorithmic trading –

The Human Factor — No intelligent system can perform at a rate what human brains could complete. So the most advanced and sophisticated technology or the most intelligent computer with lots of intelligence the personalized touch is yet needed. If Algorithmic trading is so advanced, why is it that the sales team is still employed? Shouldn’t it be an automatic program talking to prospective clients? After all sales team also “sells product”. But no, a human touch is needed. And for every client the approach is different. Same goes with the hard earned money of clients, being fed into those intelligent systems.

Short of Clarity — We know a study and tests have done on these algorithms before feeding the live orders, but it still needs manual intervention. How could we be sure that the trader would be choosing the most optimal strategy at that point? So that data set is still hazy.

Tracking of Patterns — A trader uses an algorithm for a specific period. The data and the pattern are observed, and it’s quite possible that another competitor could build the same strategy. So next time when you use a specific strategy, it could fail as the competitor is also using the same one.

Which One To Pick — This is a million dollar question. As with sell-side offering so many execution strategies all offering the best results. Buy-side firms are still figuring out a way to choose the best one.

As we just saw Algorithmic trading offers an extra edge in cutting the TCA and allowing the managers to take control of their investments. However, it has a gray side as well which reflects the inefficiency of the algorithmic trading.

So decide, analyze and choose wisely!

Hey I am Samiksha, a Fintech Product Manager currently sailing solo