Investments, tenth edition

   Algorithmic Trading 

  Algorithmic trading  is the use of computer programs to make trading decisions. Well 

more than half of all equity volume in the U.S. is believed to be initiated by computer 

algorithms. Many of these trades exploit very small discrepancies in security prices and 

entail numerous and rapid cross-market price comparisons that are well suited to com-

puter analysis. These strategies would not have been feasible before decimalization of the 

 minimum tick size. 

 Some algorithmic trades attempt to exploit very short-term trends (as short as a few 

seconds) as new information about a firm becomes reflected in its stock price. Others use 

versions of  pairs trading  in which normal price relations between pairs (or larger groups) 

of stocks seem temporarily disrupted and offer small profit opportunities as they move 

back into alignment. Still others attempt to exploit discrepancies between stock prices and 

prices of stock-index futures contracts. 

 Some algorithmic trading involves activities akin to traditional market making. The 

traders seek to profit from the bid–ask spread by buying a stock at the bid price and rap-

idly selling it at the ask price before the price can change. While this mimics the role of a 

market maker who provides liquidity to other traders in the stock, these algorithmic traders 

are not registered market makers and so do not have an affirmative obligation to maintain 

both bid and ask quotes. If they abandon a market during a period of turbulence, the shock 

to market liquidity can be disruptive. This seems to have been a problem during the flash 

crash of May 6, 2010, when the stock market encountered extreme volatility, with the Dow 

Jones average falling by 1,000 points before recovering around 600 points in intraday trad-

ing. The nearby box discusses this amazing and troubling episode.