“All the math you need in the stock market you get in the fourth grade.”
This is what the legendary investor, Peter Lynch wrote in his 2012 bestseller, “One up on Wall Street: How to use what you already know to make money” about basic knowledge needed to operate in a stock market.
Would Peter Lynch’s sagacious advice stand to reason? The consensus is yes! Of course, it would. But it may fall short when computers begin trading.
Yes, your eyes are not deceiving you. Computer systems have entered the domain of trading which was considered to be the bullpen of humans.
Algorithmic Trading is also known as automated trading, black-box trading, or simply algo trading and uses computer software that follows a pre-defined set of instructions or an algorithm to place a trade. Following defined instructions based on the timing, the price, and quantity as well as any mathematical model can increase the chances of making a profit on a trade.
Due to its many advantages, Algo trading is increasingly becoming popular with investment banks, pension funds, mutual funds, and hedge funds that require the mechanism to spread out the execution of a larger nature or perform trades that are too fast for a human trader to do.
Allowed by the Indian government in 2008, algo trading has been steadfastly replacing human traders from the market. Today, it accounts for a third of the total volume of trades on Indian cash shares and 50% of the volume of the total value of derivatives. It was introduced in the west almost three decades ago and was already trading half of the market volumes by 2012 and it quickly became 70% the year after. Such was the fervor of Algo trading that almost 80% of trades in NYSE, 60% trades in LSE, and 40% of the trades in NSE are being performed daily. A 2019 study confirmed what many had expected that algo-trading was performing a whopping 92% of the total Forex market trade.
Before we delve deeper into this phenomenon which has gripped the markets tightly, let us flip the pages of history and see how exactly ‘machines in the market’ became the new normal.
THE ADVENT OF THE MACHINE IN THE MARKET -
The computerization of the financial markets began way back in the 1970s, but it was not before the 1980s and 1990s that financial markets with fully electronic execution and similar electronic communication networks were developed for High-Frequency Trading. As the tick size in the US decreased, this change unknowingly paved the way for algo trading by allowing small differences between the bid price and offer price. And in 1998, sweeping electronic changes that brought High-Frequency Trading (HFT) to the fore were authorized by the U.S Securities and Exchange Commission (SEC) and the rest, as they say, is history.
In India, algo trading was introduced by the Securities and Exchange Board of India (SEBI) in 2008 in the form of a Direct Market Access (DMA) Facility to institutional clients. The facility helped bring down costs greatly. A big boost to algo trading was given in 2010 when SEBI approved the launch of Smart Order Routing (SOR), which made it possible for investors to place their trades without having to worry about the volatility in prices. This proved to be a booster shot in the arm for the stock markets. Thus, the participants were able to place their bets confidently and the transaction volumes increased across both exchanges.
THE WAY OF THE FUTURE -
In recent years, do-it-yourself algorithmic trading has become very popular. For instance, hedge funds like Quantopian crowdsource algorithms from amateur programmers who compete with each other for writing the most profitable code. This practice has been made possible with the help as well as the spread of high-speed internet and the development of the ever-increasing speed of computers cheaply. Quantiacs and other similar platforms serve traders who wish to take the plunge in algorithmic trading. Aside from algo trading, machine learning and pioneering developments in artificial intelligence have propelled trading to take on a whole new dimension.
Algo trading has reaped tremendous benefits for its users. A plausible scenario does leap to mind – will computer algorithms eventually pave the way for humanoid robots to play the part of brokers? Well, that’s something which remains to be seen.
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