Algorithmic trading is a term that is used very loosely to describe systematic trading. The term is often a catchphrase for any or all of the following: black-box trading, computer trading, automated trading, program trading, basket trading, enhanced execution and execution strategies. Simply put, algorithmic trading is rules-based trading.
Trading algorithms automatically break up large orders into bite sizes and feed them directly into the market. But they can be tuned to execute almost any strategy. They can attempt to capture the average price over a day or to gain an edge by, for example, trading more heavily at the opening and close, when volume is high.
An algorithm can be the trading strategy itself –- the rules that determine which market to trade and when to trade it. For example, a strategy that employs a set of technical indicators, such as Moving Average Convergence/Divergence (MACD) or On Balance Volume (OBV), is algorithmic. Such “strategy” algorithms are at the heart of most mechanical or black-box trading systems.
But an algorithm can also be employed to determine how to execute an order; i.e., given the micro-structure and liquidity of a given market, what is the most effective way to execute an order so as to reduce market impact and slippage and therefore improve trading performance? An example of an “execution” algorithm is a Time Weighted Average Price (TWAP), which breaks up a large order and executes it evenly over a set period of time. Other popular execution algorithms include Volume Weighted Average Price (VWAP), Volume Participation, Arrival Price and Pegging. Many brokers have developed customized algorithms that they provide to clients as a way of differentiating themselves and adding value.
The advent of electronic trading, first in the equity markets and more recently in the futures and foreign exchange markets, opened the door for algorithmic trading. By some accounts, up to 30% of the equities trading (as of 2007) is executed using algorithms. Algorithmic trading in futures and foreign exchanges is a growing phenomenon that helps explain the recent dramatic growth of volume in both asset classes.