Algorithmic Trading is defined as a trading system which uses innovative and advanced models of mathematics in financial markets to make transaction decisions. In addition, elaborate decisions are made by computers to initiate order on the basis of real-time data received by them. The most common use of Algorithmic Trading is by large institutional investors who make a bulk purchase of shares on a daily basis. Since, the quantity traded is huge, it might result in adverse fluctuations in stock price; hence the system is devised to divide the large share block into smaller lots. The complex algorithms decide as to when and at what price the smaller blocks are to be bought without having any major impact on the stock price and also to find out the manner in which the market would go in future and take the position in the market accordingly.
With algorithmic support, the decisions about investment and execution might be amplified at any time or can also be operated completely automatically. It performs the valuable function of increasing the volume, fall in stock spread and cost of transaction and rendering liquidity to the market. The information they receive about ‘order flow’ is similar to what other market players receive but a bit sooner because of the ‘co-location’ facility availed by them.
The issues associated with Algorithmic Trading are about the probable threats and doubts that some individuals might be utilizing a computer to operate the market. The computers have no knowledge about the management, the CEO or any other qualitative information. They only take into consideration the information which is quantifiable.
At the same time, the regulators aren’t aware of the program which is fed to the computers and hence are afraid that any loophole in the program or its execution might result in a meltdown which would have adverse impact on the other market players. A similar situation was observed on May 6, 2010 when the price of Dow Jones Industrial Average underwent its 2nd largest intraday swing in the points (a fall of 600 points in 15 minutes) and is popularly known as Flash Crash. It is suggested that necessary changes must be made by adding more transparency which would give people more confidence in the market.