I’ve been reading a lot about the stock market lately (for obvious reasons–yikes!) and there’s something that keeps coming up that I find a little confusing: algorithmic trading. I understand basically that it’s a kind of automatic trading that uses computers, but I’m confused about how exactly it works. Why would computers be better at trading stocks than humans (are stocks that logical)? Is it true that, as some people are saying, algorithmic trading is causing the stock market to decline right now? And what exactly is an algorithm in the first place? Experts, can you explain any of this to me?
We sure can!
Let’s start with the most basic of your questions: what is an algorithm? Well, it’s actually a pretty broad class of things: Merriam-Webster defines it as “a procedure for solving a mathematical problem…in a finite number of steps.” So, in essence, an algorithm is just a formal way of solving a math problem.
In algorithmic trading, we might describe the problem as something like: when should stocks be bought and sold in order to make the most amount of money by taking on the least amount of risk? Of course, different investment companies and funds may be seeking different balances of risk and potential profit, so it’s not the case that everyone is trying to solve the exact same problem–much less using the same sorts of algorithms.
But algorithmic trading (for all sorts of different purposes) has indeed been on the rise in recent years. Algorithms can be programmed into computers and designed to execute trades based on certain criteria.
It’s a powerful tool, say the developers of algorithmic trading platforms for quants. Algorithms can make human insight more powerful (picture an insightful investor coming up with a strategy, but implementing it using an algorithm in order to be able to execute trades based on it quickly and at scale). And computers can add to human insights (think of an algorithm that helps bring opportunities to investors’ attention, or one designed to draw trend insights from huge amounts of data).
It’s true enough that some see dangers in this. What if many algorithms see a problem at once, triggering a quick decline in the market (and further selling-off)? In the view of some, that’s been a contributing problem with the current market downturn.
But, on the other hand, humans are very capable of causing panics without algorithms and computers: we’ve seen that a few times in history. And there are other factors that may be at play here, including a unique (and relatively new) type of fund that bet against market volatility itself–and lost big. And, on top of all of this, it’s easy to argue that we don’t actually know much about what caused this latest dip–and may never know!
In all likelihood, algorithmic trading tactics (and regulatory rules) will be looked at again following the recent market dip. But the idea of using algorithms to trade? That’s here to stay.
“Only those who dare to fail greatly can ever achieve greatly.” — Robert F. Kennedy