Algorithm trading: Relevance
- GS 3: Awareness in the fields of IT, Space, Computers, robotics, Nano-technology, bio-technology and issues relating to intellectual property rights.
Algorithm trading: Context
- Recently, Securities and Exchange Board of India (SEBI) has proposed that all orders emanating from application programming interface (API) of stockbrokers should be treated as algorithmic trading, commonly known as algo.
What is algo trading?
- Algorithm trading is a system of trading which facilitates transaction decision making in the financial markets using advanced mathematical calculations.
- In algorithm trading, also known as ‘Black-box trading’, the computer program uses a set of instructions that helps make trading decisions and earns profits at a pace that would be difficult for a human trader to achieve.
- Algo trading, while giving profit opportunities for traders, makes markets more liquid and trading more systematic by eliminating the effect of human emotions on trading.
What is the role of API?
- Many stock brokers in India provides Application Programming Interface (API) access to their clients which establishes an online connection between a data provider (stock broker) and an end-user (client).
- API access permits the investors to use a third-party application that help them analyse market data or back-test a trading or investment strategy.
- These APIs are being used by the investors for automating their trades.
- Regulation: SEBI said that there is a need to create a regulatory framework for algo trading.
- API: All orders emanating from an API should be treated as an algo order and be subject to control by stock broker
- Algo ID: The APIs to carry out algo trading should be tagged with the unique algo ID provided by the stock exchange granting approval for the algo.
- Approval: Stock broker needs to take approval of all algos from the exchange. Each algo strategy, whether used by broker or client, has to be approved by exchange.
- System development: Stock exchanges have to develop a system to ensure that only those algos which are approved by the exchange and having unique algo ID provided by the Exchange are being deployed.
- Two factor authentication: It should be built in every such system which provides access to an investor for any API/algo trade.
Algo trading advantages
- Rule-based decision making: It ensures that all trades follow a set of rules. It is important because traders and investors are frequently influenced by feelings and emotions while taking trade decisions.
- Reduce market impact: A trading algorithm can purchase shares and check immediately to see if the transaction has influenced the market price. It lowers the transaction costs and make automated checks on several market situations simultaneously.
- Minimize human fallacy: Since algorithmic trading works based on predefined instructions, it lowers the possibility of human traders making mistakes.
Algo trading disadvantages
- Monitoring: Even though the decisions are rule-based, automated trading systems do need constant supervision. Incidents of irregularities may be quickly detected and handled if the system is monitored.
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