How Trading Algorithms Work
April 16, 2020
Estimated Reading Time: 4 minutes
How Trading Algorithms Work
Technology has evolved the way we do everything. As of today, we have smartphones, smart refrigerators, and even smart toasters (yes, they do exist). But while Alexa is burning our toast, another technology is out there driving the stock market: trading algorithms.
Trading algorithms (or algos, for short) are methods of stock trading that use mathematical models and formulas to affect high-speed, automated financial transactions. And they go beyond just stocks, too, also trading in bond and funds markets.
This post aims to cover questions like “how do algos work?” and “how do they affect the market?”
How Algos Work
An algorithm is a fancy mathematical term that describes a set of rules used to define something. In this case, the set of rules carry instructions on how to execute buys and sells on the market. The rules, or criteria, affect how much an algorithm is instructed to buy or sell, when to execute, and the price at which the transactions are executed.
Some of the criteria may be the price of a security, some may be related to market conditions, and others are based on technical or fundamental analysis of markets. Whenever one of these criteria are met, the algorithms execute extremely quickly (milliseconds).
Large institutions and brokers use these algorithms to trade large volumes of securities at relatively low costs.
Benefits of Algorithmic Trading
Because algos are computer-defined processes, they can execute before a trader has a chance to look over their cup of coffee. They may not even know a trade has executed until after the transaction is completed. This method of execution, while being extremely fast, is also extremely accurate. No human inputs means less chance of errors when entering a trade (sometimes known as the “fat finger”). And with computer scientists further refining and defining the criteria, this capacity for deep specificity allows for hair-trigger precision on these executions.
On another level, logic-based market moves act as a security against emotions and irrational investing, like having Hal behind the transactions instead of a human. By removing the emotional aspect of trade execution, more logic-based plays can be input ahead of time, leading to a stronger reason-based investment strategy.
Drawbacks Included
While Hal may be the most precise trader, he is not without his weaknesses. For example, an algorithm is only as good as the programming behind it. If the algorithm is not using the right criteria, or has excess criteria, it may miss its mark. Or, if it is using the wrong criteria entirely, or has the wrong purchase or sell amount, there can be catastrophic consequences. The human aspect of trading is removed, but the human programming behind the computer can still have its own faults.
Volatility can also be a drawback. As we saw in March of 2020, the market turned downwards more quickly than any other time in history. While we can attribute some of the decline to emotional investing, the overall fall was exacerbated by the trading algorithms. In times of high-volatility, algorithms may not perform as well.
And as the market conditions change, the algorithms must also adapt. These changes must be made manually by the programmers, and, if left unchecked, may result in trades that are not beneficial to the overall strategy.
Flash Boys
In a few words, algos are built to be fast and precise. While they have their drawbacks, the constant evolution of these machines will continue to be a factor in trading in the future.
If you are interested in learning more about algos, Author Michael Lewis wrote about the rise of algorithmic trading in his novel Flash Boys, which shows the landscape where algorithms were created, and the fierce competition in the innovation of better and faster algorithms.
Important Disclosure Information
Past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Chicago Partners Investment Group LLC (“CP”), or any non-investment related content, made reference to directly or indirectly in this commentary will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from CP. Please remember to contact CP, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. CP is neither a law firm nor a certified public accounting firm and no portion of the commentary content should be construed as legal or accounting advice. A copy of the CP’s current written disclosure Brochure discussing our advisory services and fees continues to remain available upon request.
April 16, 2020
Estimated Reading Time: 4 minutes
How Trading Algorithms Work
Technology has evolved the way we do everything. As of today, we have smartphones, smart refrigerators, and even smart toasters (yes, they do exist). But while Alexa is burning our toast, another technology is out there driving the stock market: trading algorithms.
Trading algorithms (or algos, for short) are methods of stock trading that use mathematical models and formulas to affect high-speed, automated financial transactions. And they go beyond just stocks, too, also trading in bond and funds markets.
This post aims to cover questions like “how do algos work?” and “how do they affect the market?”
How Algos Work
An algorithm is a fancy mathematical term that describes a set of rules used to define something. In this case, the set of rules carry instructions on how to execute buys and sells on the market. The rules, or criteria, affect how much an algorithm is instructed to buy or sell, when to execute, and the price at which the transactions are executed.
Some of the criteria may be the price of a security, some may be related to market conditions, and others are based on technical or fundamental analysis of markets. Whenever one of these criteria are met, the algorithms execute extremely quickly (milliseconds).
Large institutions and brokers use these algorithms to trade large volumes of securities at relatively low costs.
Benefits of Algorithmic Trading
Because algos are computer-defined processes, they can execute before a trader has a chance to look over their cup of coffee. They may not even know a trade has executed until after the transaction is completed. This method of execution, while being extremely fast, is also extremely accurate. No human inputs means less chance of errors when entering a trade (sometimes known as the “fat finger”). And with computer scientists further refining and defining the criteria, this capacity for deep specificity allows for hair-trigger precision on these executions.
On another level, logic-based market moves act as a security against emotions and irrational investing, like having Hal behind the transactions instead of a human. By removing the emotional aspect of trade execution, more logic-based plays can be input ahead of time, leading to a stronger reason-based investment strategy.
Drawbacks Included
While Hal may be the most precise trader, he is not without his weaknesses. For example, an algorithm is only as good as the programming behind it. If the algorithm is not using the right criteria, or has excess criteria, it may miss its mark. Or, if it is using the wrong criteria entirely, or has the wrong purchase or sell amount, there can be catastrophic consequences. The human aspect of trading is removed, but the human programming behind the computer can still have its own faults.
Volatility can also be a drawback. As we saw in March of 2020, the market turned downwards more quickly than any other time in history. While we can attribute some of the decline to emotional investing, the overall fall was exacerbated by the trading algorithms. In times of high-volatility, algorithms may not perform as well.
And as the market conditions change, the algorithms must also adapt. These changes must be made manually by the programmers, and, if left unchecked, may result in trades that are not beneficial to the overall strategy.
Flash Boys
In a few words, algos are built to be fast and precise. While they have their drawbacks, the constant evolution of these machines will continue to be a factor in trading in the future.
If you are interested in learning more about algos, Author Michael Lewis wrote about the rise of algorithmic trading in his novel Flash Boys, which shows the landscape where algorithms were created, and the fierce competition in the innovation of better and faster algorithms.
Important Disclosure Information
Past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Chicago Partners Investment Group LLC (“CP”), or any non-investment related content, made reference to directly or indirectly in this commentary will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from CP. Please remember to contact CP, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. CP is neither a law firm nor a certified public accounting firm and no portion of the commentary content should be construed as legal or accounting advice. A copy of the CP’s current written disclosure Brochure discussing our advisory services and fees continues to remain available upon request.