ALGORITHMIC TRADING

Hierarchy of terms

Beginning in the late 1990s, the electronification of execution venues enabled market participants (banks, brokers and their institutional and retail clients) to remotely access electronic order books. Electronic trading refers to the ability to transmit orders electronically as opposed to via telephone, mail, or in person. Since most orders in today’s financial markets are transmitted via computer networks, the term is rapidly becoming redundant.

Algorithmic trading (AT)

AT is more complex than electronic trading; it is an umbrella term which does not necessarily imply the aspect of speed typically connoted with HFT. Algorithms were originally developed for use by the buy-side to manage orders and to reduce market impact by optimising trade execution once the buy-and-sell decisions had been made elsewhere. Hence, AT may be defined as electronic trading whose parameters are determined by strict adherence to a predetermined set of rules aimed at delivering specific execution outcomes. Algorithms typically determine the timing, price, quantity, and routing of orders, dynamically monitoring market conditions across different securities and trading venues, reducing market impact by optimally and sometimes randomly breaking large orders into smaller ones, and closely tracking benchmarks over the execution interval (Hendershott et al., 2010).

High-frequency trading (HFT)

HFT is a subset of algorithmic trading where a large number of orders (which are usually fairly small in size) are sent into the market at high speed, with round-trip execution times measured in microseconds (Brogaard, 2010). Programs running on high-speed computers analyse massive amounts of market data, using sophisticated algorithms to exploit trading opportunities that may open up for milliseconds or seconds. Participants are constantly taking advantage of very small price imbalances; by doing that at a high rate of recurrence, they are able to generate sizeable profits. Typically, a high frequency trader would not hold a position open for more than a few seconds. Empirical evidence reveals that the average U.S. stock is held for 22 seconds.

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