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Algorithms, HFTs and Flash crashes

V Subbiah Ganesh | 23 Apr, 2012  | Follow Author | Add to my Favourites 

Algorithm is a step by step process which involves a formula or a set of rules to solve a problem.In day to day life one or the other household equipments we have, operate on an algorithm.Take for example- A Washing Machine, which has got a set of rules for washing,rinsing and drying.The machine operates on this algorithm and in the event of any anomaly, the machine informs us through a beep sound.It cannot auto correct the mistakes or the anomaly and hence it doesn't fall under machines with artificial intelligence.It needs human intervention to work normally.Same is the case with many algorithmic trading programs which are being used by the FIIs and investment bankers or some technocrat traders.Algorithm doesn't have any intelligence on its own.It does what exactly it is programmed to do.Yes, you heard it right.It is similar to my office boy.You ask him to buy a soft drink and if the store doesn't have it, he will come back saying that it is not there.He will not call you to ask, whether he can buy the other available brand at the store.And you have to send him again.

On the other hand the HFT- High frequency trading uses lot of algorithms to execute different orders in a trading day.It executes even thousand orders a day and mostly the trade position is held for few minutes to few hours.By the end of the day there are no trading positions left.Every trader has a few tricks up his sleeves in trading.But the limitation is the process of executing it lightening fast before the market could react.There is were HFT kick in as they have less than a micro second execution time.The organizations which use HFT reduce the volatility of a particular script by creating a market for the particular script.In other words, they act like market makers thus reducing the volatility and bid-ask spreads.

And what happened to Nifty on Friday is like a flash crash.It happened within seconds.Infosys dropped around 18-19% during the time and recovered before the markets were closed.Some of my friends attributed this to the error in order punching in both the INFY and the Nifty futures.This lead to the fall as a huge order got executed (a sell order) without the price being mentioned and it got traded to all the available buy orders.This happened within seconds and the markets recovered rapidly.In my opinion it should be because of a punching error and suddenly the algorithms and HFT systems started executing their orders as the prices started dropping and this resulted in the flash crash.In May 2010, DOW Jones fell about 1000 points within seconds and recovered most of the fall before the end of the day.This was attributed to the error in order punching and resulted in a flash crash as the HFT and algorithm picked the signal of the sudden fall and started executing the orders.This all happens within micro-seconds leaving no space for human intervention.

No matter what system you use for trading, be it technical analysis or Macro-economics or you trade on the calls given to you by a friend who claims to be an analyst,kindly have a strict stop loss in place.Don't have the stop loss order in your mind.Have it punched in into the trading system.The advantage of doing so is, you can avoid emotions while the prices are nearing your stop losses and less human intervention is possible on days where we see a flash crash.

Reader's Comments

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Skeptical Investor on Jun 11 2012 said:
Algo trading is highly over-rated, it earns volumes for exchanges and brokers - but since risk is impossible
to understand (leave alone measure), eventually you will lose your money. If computer programmers could make
money like this, why would they remain programmers or work for anyone else?



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