All you want to know about

A computer driven algorithm sniffing around a complex grid of stock market orders, suddenly starts flashing green and goes beep beep. It has spotted a large institutional order. It fires a barrage of counter orders in just one millisecond. If you thought this was sci-fi, you would be mistaken. This is an everyday occurrence in stock markets. Algorithmic trades have been around for over a decade now. It is just that the debate on whether they are good or evil has been revived, thanks to Michael Lewis’s Flash Boys .

What is it? In algo trades, the trader feeds a computer programme into system and allows that program to put in all his trading orders and execute them too, while he leans back on his chair, smoking his cigar. High Frequency Trades (HFT) — about which there is a big hue and cry of late-- are a sub-set of these machine driven algo trades.

There are many different kinds of algo programmes. Some programmes slice a large order into little bits and spreads out the orders through the trading session, so that the price is not unduly affected by the order. Another kind of algorithm identifies anomalies between the price of an asset in different exchanges or markets and cashes in on these differences. Then there are algos that follow a set of technical parameters to buy and sell stock with split second timing.

These algos are harmless, but computers being just machines, they can be easily used for more underhand activities as well. There are some roguish programmes that sniff the outstanding orders in other systems and take advantage of them. This is the kind of algo that Michael Lewis talks about. Then there are algos that make bluff trades so that other programmes reveal their intended trades. They then go on to cancel these bluff trades.

Why is it important?

Algo trades account for more than two-third of the trades in US and UK. But we Indian are too far not behind. On the National Stock Exchange these trades account for around a third of the spot volumes and about 45 per cent of equity derivative market. Regulators world-wide are trying to find means to regulate these trades. But the jury is still out on whether these trades part of natural progression in stock markets that should be allowed to flourish or if they are an aberration that should be curbed.

Why should I care? If you are an avid trader in stock markets, chances are high that you are already using algorithmic software to improve your hit rate. Those in favour argue that liquidity in markets have improved and difference between a buy and sell order has reduced due to these programmes.

The detractors say that these machine-driven trades have an unfair advantage because they put in a high-speed trade before any other investor becomes aware of it. There are also traders who have moved their terminals close to the exchange server to improve their speed even further and gain an edge over others who trade from remote locations. Some of these algos also bombard the exchanges with multiple orders thus swamping the system.

The bottomline Algo trades are hard to regulate. But such trades have grown so big in number that they can not be banned without causing serious harm to market’s liquidity and price discovery process. Love ’em or hate ’em, there is no getting away from ’em.

(A weekly column that puts the fun into learning)

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