Algorithmic and High Frequency Trading in India

by Manshu on October 31, 2011

in Investments

Algorithmic trading or algo trading is the use of computer programs and software to execute trades based on pre – defined criteria and without any human intervention. High Frequency Trading (HFT) is a subset of algorithmic trading, and this type of trading involves buying and selling thousands of shares in fractions of seconds.

HFT came into spotlight about two years ago when Goldman Sachs sued one of their former employees for stealing code that was used in one of their programs used to execute this type of trade.

For a while, newspapers were all over this story, but with time the attention faded. This event helped bring to light something that most regular investors didn’t know about – that large institutional investors have been allowed to place their servers in the same building as the stock exchanges, and they are able to gleam at transactions a few milliseconds before the other market players do.

The NYT later did a full story on HFT and while the actual way HFT works remains a bit of a mystery, it did help clarify that these big players get trade information milliseconds before other players, and as a result they can trade on this information and trade on the spreads that exist at that point in time. That article had an example of how this affects share prices and they used a $1.4 million order on which they said the slow moving investors had to pay $7,800 extra because of high frequency traders which is about half a percent more on the trade than they would have otherwise had to. An ET article that appeared recently quoted NSE’s Chief Technology Officer stating that the impact cost of high frequency trading on the NSE is 0.07% – 0.08%.

Since these operations are rather opaque, and these are just two numbers I think it’s not reasonable to compare them, but in terms of the impact that they currently have on prices, I think a long term investor is not impacted a whole lot by the small price changes either in India or in the US.

However, in May 2010 – a flash crash took place in the Dow in which several companies and blue chips lost a lot of their value in a matter of minutes, and the NYT reported that shares of big companies like P&G and Accenture saw ridiculous prices like a penny or a $100,000. The prices were later restored to more usual levels.

The SEC investigated this, and said that while the starting point of the flash crash was a mutual fund legitimately hedging its position by selling mini S&P Futures – a confluence of factors, primary among which was HFTs getting in on the trades, and then suddenly stopping altogether caused this market distortion.

Although, there weren’t any reports of regular investors losing money because of these events, it does show that these computer trading programs pose risk, and can cause damage because of the way they are structured. Even in India – BSE canceled all the futures traded on muhurath trading this year, and at least an initial report blamed an algo trader from Delhi for causing havoc because of their trades.

Since no one wants to talk about actual volumes that can be attributed to algorithmic trading – it’s hard to say how big it is in either India or in the US, but I think the fact that no one wants to disclose it shows that it must be reasonably large.

These were the similarities between the US and India, but there is a difference too. It appears that while it’s only a question of how profitable these operations are in the US and whether the profits of firms that engage in this runs in billions or tens of billions; in India – the profitability is itself questionable.

I don’t know how far this is true, and I’m certainly skeptical about it – but maybe they don’t have enough volumes or enough of an edge to be as profitable as they are in the US.

To summarize what we know:

Algo and HFT exists in good volume in India, and while the difference it makes on an individual trade is very low, it is capable of causing wildly large market movements. So far, we have not seen any real damage because of these swings, and exchanges seem to have things under control.

Now, as far as a small investor is concerned, unfortunately even if you don’t agree with the argument that HFT provide liquidity to the market, and are an essential part of the market there is not much you can do about it and you need to really focus on stuff that you do have control over.

What you can do is always place limit orders, and not sell in this kind of panic – that’s all which is in your control, and rather than fretting over half a percent I think small investors are better served focusing on things that are in their control.

Personally, I don’t see any utility in HFT and find it unfair that someone should get information before others, if only for a few milliseconds, and don’t buy the argument that they really do contribute to liquidity. The markets were working quite fine without them for decades, and that someone by virtue of their size gets an edge on other market participants seems unfair to me.

This post was from the Suggest a Topic page.

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