Quick definition Algorithmic trading is the use of computer programs to execute trades automatically. Algorithms follow predefined rules and can execute thousands of trades per second. What it is An algorithmic trading system monitors market conditions and automatically places and cancels orders. For example, an algorithm might buy whenever the price drops 1 percent and sell whenever it rises 1 percent. Algorithms are used for execution (e.g., VWAP algorithms) and for proprietary trading (e.g., statistical arbitrage). Execution algorithms serve the trader's intent (get a large order filled efficiently). Proprietary algorithms aim to profit directly from market movements. Why it matters Algorithms can respond to market conditions faster than humans. They execute thousands of trades per second. Algorithms also execute with discipline and emotion, following rules precisely. Algorithms also reduce human error and operational costs. A human trader needs supervision and benefits; an algorithm runs unattended. Risks Algorithms can malfunction and cause significant losses. The "Flash Crash" of 2010 was partly caused by algorithmic selling that cascaded into a market-wide decline. Algorithms can also be exploited by adversaries looking to trigger specific algorithmic behaviour. Algorithm strategies Common algorithmic strategies include: - Execution: minimise market impact (VWAP, TWAP) - Arbitrage: exploit price differences across venues - Trend-following: buy momentum, sell downturns - Statistical arbitrage: identify correlations between securities Practical example A VWAP execution algorithm is tasked with buying 1 million shares. It monitors volume throughout the day and buys in proportion to expected volume. By day end, it has purchased all 1 million shares at an average price close to VWAP. Regulation Algorithmic trading is regulated to prevent market abuse. Algorithms must be tested before deployment. Exchanges monitor for suspicious patterns that suggest market manipulation. See also - Execution Algorithm - High-Frequency Trading - Statistical Arbitrage - Flash Crash
