Algorithmic trading — spot the opportunity & leave it not!

Rajalakshmi Sivam | Updated on March 12, 2011

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For traders who are in the hunt for arbitrage opportunities in the market, we explain how algorithmic trading works this week. Algorithmic trading refers to automation of the process of placing orders by using a software that runs on mathematical programs.

One of the key applications of this software that runs on a coded algorithm is — arbitraging. Jobbers, who play on the price differences between the NSE and the BSE or spot and futures market, needn't stare at multiple screens to identify an opportunity for arbitrage.

Quick spotting, precision in deciphering a trade's worth and order execution speed are highlights of algorithmic trading. By avoiding human intervention and by connecting to the stock exchanges directly (by what they call a direct market access - DMA), algorithmic trading enables swift order execution.

The algorithmic software can execute some of the very complex limit orders too. What more? You can customise the software to fit your trading strategy.

Algorithmic trading: What is it?

As math students we know algorithm as a formula to solve problems. Algorithmic software too does just the same.

Traders, who have complex conditions for stock picking, get them written as software programs and completely automate the process of spotting the opportunity as well as executing the order. In India, traders use algorithmic trading mostly for arbitraging in the market.

Arbitrage opportunities do not stay in the market for long; they disappear in a wink of the eye as hundreds of jobbers wait to jump on them.

For traders who want to enhance the execution speed of their orders and have a quick refresh of the ticker, can actually connect to the exchange's server through a LAN. Asking me how? Traders who use the algorithmic software can actually approach the exchanges and make a request to place their terminal in the exchange's premises and connect to the exchange's server through local-area-network rather than using wide-are-network (meaning the internet). Let's now see how the algorithmic software works:

Step 1: As the opening bell goes, price feeds from different exchanges flow into the trader's terminal.

Step 2: The algorithmic software monitors price ticker and will be in a constant search for opportunities to execute the set orders. On finding matching set of data, orders are triggered and they fly to the exchange in rapid speed.

Step 3: The order hits the exchange's server and gets executed, sending back a confirmation to the trader.

Who is the vendor?

There are many vendors out there selling software programs for algorithmic trading. But, it is better to buy it through your stock broker. Two reasons for this — one your stock broker can work with the software programmer to write your strategy as code for the software and two, he will take care of getting approvals for the software from the exchange.

Yes, all algorithmic softwares have to be approved by the exchanges for the program that has been coded in it.

The readymade software programs for algorithmic trading however have all the basic requirements of a normal trader, says Trivikram Kamath, Executive Vice-President Operations, Finance and Technology, Kotak Securities.

Yes, it will have coded algorithms that help identify arbitrage opportunities between exchanges, between cash and futures market and also those between the near and far month future contracts of a stock.

In terms of hardware for using the software, there are no special requirements. Any computer system with basic configurations (should be Java-enabled) that support online trading with high speed broadband connectivity would suffice.

Price (of the software) here varies on several parameters — whether it is readymade or custom designed, is it a single user or a multi-user product, etc.

Some vendors actually charge the buyer on per trade executed through the software. And, here, it appears that your negotiation skill will get you some better rates!!

Risks involved

In using an automated system, there are risks that tag along. Traders operate on a ‘gut' feeling — it is the moves in the market which decides their action.

Since human intervention is entirely eliminated while placing orders through programmed algorithms, there is no scope for this.

Though the software allows order modifications, it may actually be too late before one resets the order!! Interest for algorithmic trading though is picking-up, traders aren't aware of the risks attached says Mr Kamath — “Traders should understand the risk involved in a computer pushing out the orders and they having no control over it. These software programs of course have various trigger points to stop the order from going but the risk is always there…”.

Published on March 12, 2011

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