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Finance

What is Algorithmic Trading?

By Adam Hill
Updated May 16, 2024
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In the financial markets, there are nearly as many trading strategies as there are investors and traders. The markets are increasingly accessible electronically, opening up even more possibilities for the development of trading systems. One of these is algorithmic trading, a trading system that uses advanced mathematical models called algorithms for making decisions and transactions in the financial markets. A computer, programmed with an algorithm, will enter electronic trading orders when certain technical conditions are met. These conditions can include timing, price, the quantity of the order, and general market trends, among other factors.

Algorithmic trading is most widely used by large institutional investors such as hedge funds, mutual funds, and pension funds. This is the case because the advantages it presents are most relevant to large funds. When a fund buys a large quantity of a given stock, for example, this can have the effect of raising the price of the stock enough to negatively impact the profit margin that the fund hoped to achieve. However, with algorithmic trading, it is a simple matter to divide one large trade into several smaller trades to reduce the market impact.

Institutional investors have the further advantage of the speed with which automated algorithmic trading programs can make decisions. When market information is received electronically, trading decisions are made automatically, often without the necessity of any human intervention at all. Decisions are made, and orders are initiated before human traders are even aware of the information. This constitutes part of the large competitive edge that hedge funds and similar traders can have over individual investors.

Trading algorithms themselves have a much longer history than algorithmic trading. An algorithm simply refers to a sequence of steps to recognize patterns in real-time market data to detect trading opportunities. Historically, investment firms would employ a large number of individual traders to manually carry out the process of building trading algorithms. However, with the advanced technologies available now, it is a much faster process to build trading algorithms and put them to use, and many fewer personnel are necessary. Algorithmic trading has effectively replaced many of the personnel formerly needed by investment firms.

Traders are still necessary, though, for algorithmic trading to be employed. In many cases, a trader will monitor the data of many algorithms at once on a digital dashboard, making the trader much more productive. The work of traders and analysts is also still needed in order to devise new algorithms and to optimize existing ones.

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Discussion Comments

By David09 — On Jul 31, 2011

@Mammmood - Nowadays you can buy advanced stock market software that uses mathematical models and technical analysis to help you buy and sell at the right time.

I think the software would be a good tool for such an approach. For me, looking at technical charts all day long would make my head spin. I do agree, however, that even this software is not magic. If it were, everyone would be using it.

However, it does do a lot of the hard work, in my opinion, and helps you make a reasoned decision in the end, all other things considered.

By allenJo — On Jul 30, 2011

@Mammmood - While I do agree that algorithms help, they aren’t magic bullets. If there were an algorithm that always made the best investment decision, the inventor of the algorithm would be rich and the SEC would have probably have to step in and put a stop to it. It might be considered insider trading.

The article says that eventually investment decisions always get bounced to real live people and that’s as it should be. As long as you don’t put all of your eggs in one basket, you should come out okay in the long haul with your stock market investments.

By Mammmood — On Jul 30, 2011

I wish I had access to algorithmic trading back when I jumped into the stock market at the height of the Internet bubble. I might not have lost any money.

Computers don’t have emotions. They will make buy and sell orders based on market data and trends, not on gut feelings, instincts or fear. These are the problems that haunt investors, especially newbie investors like me (at the time).

Of course, individual investors do have something loosely similar to algorithms. They’re called stop limits so that you can tell your account to sell when a share hits below a certain price.

In that sense, you’ve taken your hands off the decision a little bit. The problem is you’re always wondering if a stock will rebound, and whether you really need to sell. Computers don’t “wonder,” however.

Anyway, live and learn I suppose.

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