Last week, SEBI announced new norms to make algorithmic trading more accessible to investors. It also proposed a stricter monitoring of these trades to ensure the smooth functioning of the market. Algo trading is already quite the rage among institutional investors and accounts for 35-40 per cent of turnover on the Indian exchanges.

What is it?

Algo trades, short for algorithmic trades, are orders executed on the exchange platform by computers through a programme designed by the user. Algo trades were introduced in India in 2009 and have seen rising interest from large domestic and foreign institutional investors, who trade on proprietary books. Algo trades can involve different degrees of manual intervention. In zero-touch algos, programs identify the trading opportunity and execute it too without any manual intervention. Here, the trades may be initiated by pre-set technical levels or quantitative indicators or arbitrage opportunities in the market, depending on the client’s preference. But more commonly used algos in India use Application Programming Interfaces (API) that allow investors to select their strategy, programme their requirements and then execute it from the broker’s end.

While the terms algo trading and high frequency trading (HFT) are often used inter-changeably, they aren’t really the same. HFT refers to high-volume orders executed within split-seconds to make immediate gains from market opportunities. HFT trades are often backed by algos, which spot the trading opportunity. The success of most algo trading strategies depends on the speed of execution, which in turn depends on the bandwidth of the connection and also the distance the data packets have to travel. It is for the second reason that institutions eye co-location at the exchange premises — where exchanges allow traders’ servers to be right next to theirs.

Why is it important?

Algo trades help institutional investors ratchet up the efficiency of trade execution and spot fleeting trading opportunities. They also add liquidity to the market. But they have their flip side too. Algo trades have often been blamed for wild swings and flash crashes in the market. When markets or stocks hit key milestones, such as say a 200-day moving average or 52-week high/low, algos may trigger a large volume of trades that magnify the trend. India does have stringent regulations in place for algo trades. The exchanges where algos are used, need to get their programmes approved from the watchdog – SEBI, before they are put to use. Now, the rules have become tougher. Stock exchanges have to allot a unique identifier to each approved algorithm and ensure that each order is tagged with it. This is expected to help surveillance. To check price swings, SEBI has also said that penalty would be levied on algo orders placed more than 0.75 per cent away from the last traded price.

Why should I care?

You may not personally use algos, but if you are in the market, you need to know how they are used by other investors. A key concern with HFT and algos is that if there is a bug in the programme, it can result in losses to lakhs of investors. In 2010, during the Muhurat trading session, volumes in the BSE derivative segment shot up sharply. This was attributed to an error in the algorithm of a share broker in Delhi, which saw buy and sell orders repeatedly being executed on the derivative platform. Sometimes trader errors or typos can cause stock prices to run riot if HFT or algo trades piggyback on the trend.

The bottomline

Speed thrills, but kills. This holds good not just for drivers, but also for investors in the markets.

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