Algorithmic trading is indeed an innovative and modern way to trade in stocks. As stated by National Stock Exchange (NSE), it shall mean and include any software or facility by the use of which, upon the fulfillment of certain specified parameters, without the necessity of manual entry of orders, buy/sell orders are automatically generated and pushed into the trading system of the exchange for the purpose of matching. The Securities and Exchange Board of India (SEBI) has allowed exchanges to extend algorithmic trading facility to members involving usage of various decision support tools / algorithms / strategies.
It is a process of trading in financial markets by using new age mathematical tools and techniques. This technique is also referred to as automated or blackbox trading. By using this form of trading, human intervention is reduced to a miniscule extent. Trades are executed faster than you would have ever imagined. It is a pre-programmed software where trades are defined using various parameters such as price, time of execution, number of shares, etc. High Frequency Trading (HFT) is a part of algorithmic trading where trades are accompanied by high turnover and high order-to-trade ratios. It is quite a popular form of trading in USA and now picking up in India as well. SEBI has issued specific set of guidelines in this regard.
The super computer with this loaded algorithm tries to capture the difference in buying and selling price. This is usually known as bid-ask spread. It covers the cost for the dealer which incur in processing the trade. Only when this happens, the dealer can generate reasonable profits for the investor. According to a latest study, stocks in the top 20% in terms of trading volume had an average spread of only 0.62% of the price while the stocks in the bottom 20% had a spread of 2.06%. So, higher the volatility in stocks, better the opportunity to earn more.
However, algorithmic trading is not as simple as it looks. Traders need high end servers to make faster trades and make the best use of available opportunities. Hence, the ones who make the most of this type of trading are large institutional investors such as banks, mutual funds and insurance companies. This premium service is also available through few interactive brokers who have application program interface (API) and get global data feeds. They levy additional charges if users want to trade this way. The trading volume is close to 35-40% in India whereas it is 70-75% in USA.
Concluding Remark
This trading method is set to increase rapidly in the coming few years in India. However, as of now, this is a costly affair and is only limited to an elite category of people. It could reach others in case there is rise in the number of vendors and developers.