Sunil Kumar Singh
With the help of algorithmic and high-frequency trading strategies, stock traders in india and world over are getting faster access to streaming real-time market data and are executing order in milliseconds. But what importance these trading strategies hold for a retail stock market investor in india?
Trading in stocks, commodities or currencies has seen generational change in terms of technology application and today it has gone much beyond using just phone, fax or emails. If you've been an avid investor in indian stock markets or least a keen market observer, you must have remembered the age-old style of stock trading - called open outcry system - prevalent in early 90's before electronic trading was introduced.
Cut to the present. Stock trading in india is on the cusp of a grand makeover where trading is being done in one thousandth, yes you read it right, of a second.
Enter the world of high-frequency trading (hft) and algorithmic trading!
However, the stock market regulator, sebi, is known for expressing reservations against hft and algorithmic trading (or algo trading) and, on a couple of occasions, its chief UK Sinha has favored limiting speed of these computer-driven advanced trading techniques, citing risks they pose to the entire financial market.
Just a few weeks back, speaking at a conference he is reported to have said, “earlier, it was 200 micro second speed, then 20 micro second and then 8 micro seconds, and there are still demands to reduce it even further. At some stage, this has to stop. What we need to look at is whether it is serving any public good.”
Sinha is not alone who's sounding caution over hft and algo trading. There's been a debate globally on the usefulness of these fast trading strategies where large institutional investors allegedly get the crucial price advantage owing to the breakneck speed at which trading is executed by using these trading techniques.
But what exactly are hft and algo trading and how they actually execute trade which is humanly impossible? This report is an attempt to demystify hft and algorithmic trading and explain the related concepts.
Algo trading
Simply speaking, algo trading is an automated trading system that utilizes very advanced pre-programmed mathematical models for making transaction decisions in stocks, currencies or commodities. Algo trading is mainly used by large institutional investors due to the large amount of stocks they deal with every day.
Large blocks of shares are usually purchased by dividing the large share block into smaller lots and allowing the complex algorithms to decide when the smaller blocks are to be purchased.
In other words, an algo trading strategy uses mathematical formulas to track real time market data and execute trades with minimum impact on the market. However, complex algorithms allow investors to get the best possible price without significantly impacting the stock's price and increasing purchasing costs.
In india, back in 2009, sebi had allowed brokers to offer algorithmic trading facilities to institutional clients in order to cut transaction time and for speedy trade execution. Further in May 2010, the national stock exchange's wholly-owned subsidiary nse.it had launched two software products - algostudio and strategystudio - which help brokers in algorithmic trading on both bse and nse.
High-frequency trading
High-frequency trading or hft is a bit different from algo trading. The basic difference lies in the fact that while every hft is algorithmic, every algorithmic trade is not necessarily high frequency. In other words, while algo trading uses pre-programmed mathematical models to track real time market data, hft employs super fast computers to track even the minutest price discrepancy in stocks, currencies and commodities, and execute orders in a millionth part of a second in order to make profit by quickly buying and selling stocks at the slightest price differential.
As per estimates, algo trading and hft account for as much as 60 per cent of transactions on the new york stock exchange and nasdaq, the two of the world's most liquid bourses. However, in india their share is miniscule.
“From reliable source, we came to know that only 20 to 25 per cent of the volume of nse, but nse not given any official confirmation,” says sanjeevi. G, vice president, derivative strategies & automated algorithmic trading, fortune wealth management company India, Coimbatore.
Obstacles
In india, although the volume of trading commanded by algo trading and hft is not as huge as in advanced western markets, but it is expected to gain momentum in the coming years. There're many challenges to overcome before hft and algo trading becomes a popular trading strategy in india.
The first is shy-high running cost of hft and algo trading platform. For example, as Sanjeevi. G says, to install and operate five terminals of hft platform it costs a whopping rs 1,00,000 per month and v-sat connection is a must. Secondly, the inbuilt strategy which is extended by the hft venders is suitable only for institutions. Thirdly, lack of experience staff in this field is another obstacle, according to him. The statutory legal charges are another obstacle and stamp duty between the states should be rationalized, he adds.
Pros & cons
However, like any new technology or concept, algorithmic trading and hft too have had their own share of controversy with many fearing misuse of these technologies and large institutional investors getting undue advantage over small investors who lack access to these sophisticated technologies.
Nevertheless, as Sanjeevi. G says, “We find only advantages in algorithmic trading and hft, no doubt it will bring more volume and liquidity in Indian equity market.”
One of main advantages of algorithmic trading and hft is that human errors are eliminated, he says. Besides, trading is 100 per cent disciplined and in a pre-determined way. Further, since the parameters are pre-fixed trading is away from greed and fear.
In addition, he says, arbitrage transactions are possible only through hft now a days and it can be used 24*7 and simultaneously in different asset classes in number of exchanges.
He says not only institutional investors, hft and algo trading are beneficial to even small investors for above reasons.
Flash crash
The term 'flash crash' was coined following the us stock market's sharp plunge and recovery on may 6, 2010. This was the first and the last incidence of flash crash.
The 'flash crash' is attributed to the massive plunge of 700 points on the dow jones industrial average (one of the most closely-watched us benchmark indices) before recovering in a matter of minutes. The sell order was executed so fast that it set off a sudden and wild fluctuation on the index and wiped off nearly $1 trillion of investor wealth within minutes.
The flash crash brought into focus some of the dangers of fast trading. There were allegations that the blinding speed at which high-frequency trade is executed led to the crash. Even subsequent investigations by the us authorities revealed that hft aggravated volatility and sell off with its rapid-fire trading techniques.according to the findings by the us commodity futures trading commission and the us securities and exchange commission, on may 6, 2010, the prices of many us-based equity products experienced an extraordinarily rapid decline and recovery. That afternoon, major equity indices in both the futures and securities markets, each already down over 4 per cent from their prior-day close, suddenly plummeted a further 5 to 6 per cent in a matter of minutes before rebounding almost as quickly. Many of the almost 8,000 individual equity securities and exchange traded funds traded that day suffered similar price declines and reversals within a short period of time. Following the crash of may 6, 2010, stock market regulators worldwide, including in india, have become extra cautious and have been taking steps to regulate automated trading when prices swing too wildly. As sanjeevi. G says says, “our regulators are closely watching the developments in this field to prevent flash crash.”
