Algorithmic Trading is Everything – Investing is Dead

As you know Fund Manager’s tell you to give them your money and leave it with them for the long term. Yet they take that money and trade it. A managed fund can churn its stock portfolio up to 125% in a year.

That means they are NOT investing. They are trading, trying to make a few cents on a trade using huge volume and hopefully booking a few million in profits.

You end up paying the transaction costs, any research fees or recommendations that justify this trading and of course taxes on any profits.

So don’t be fooled into thinking your retirement nest egg is being wisely invested for long term growth and steady returns. Its a trading war out there and now ultra high speed trading platforms are being installed in investment banks, hedge funds and managed funds offices to implement algorithmic trading.

Algorithmic trading has been going on for some time and most of the investment banks and hedge funds used it well before the stock market melt-down. So what is it?

It is used by large institutional investors to make very large purchases of stocks using multiple trades without necessarily drawing attention to themselves. The aim is to get the best possible price before others jumped on the band wagon to send the stock price up.

When you’re dealing in millions of shares and looking for a few cents of profit your entry price becomes very important.

Buying at the best price seems the right thing to do for your investors. However these trading systems will also sell just as quickly or even cancel millions of orders if the trend changes. We’re talking milliseconds here, not days, weeks or years.

Milliseconds can make the difference between a big profit or a big loss when maybe 40% or more of all trades are now done using Algorithmic trading systems. “The Need for Speed Article shows how fast algorithmic trading is becoming the norm.

“According to a study by Boston-based TowerGroup, a division of MasterCard Worldwide, algorithmic trading will push direct market access trading (trading without broker intervention) to 38% of total buy-side flow by 2008. In 2006, 27% of U.S. hedge fund trading, and 16% of trading by large institutional investors, flowed through algorithms. A recent IBM study suggests that around 40% of the trades made on the London Stock Exchange may now originate from algorithmic trading systems.”

It’s all about trading faster and faster as that is the new “edge” in the market. A fraction of a second can make all the difference between a fat profit or a terrible loss.

In fact speed is so important that institutions are paying NASDAQ and other exchanges to house their trading servers. Why? because the computers are so fast they are not the limiting factor anymore. It is the physical distance between the institutional server and the exchange that will determine the price an order gets filled at. If your server is across town you just won’t be in the game. It’s a real revenue earner for NADAQ too. If you want to be close to NASDAQ be prepared to pay a colocation fee but the benefits will be there,

“By colocating, these firms are putting algorithms in the location that’s going to get transaction turnaround in just a couple of milliseconds, as opposed to what could be 20 to 30 milliseconds for the data to travel across the country,” he says. “Twenty milliseconds make a difference in terms of what price you get per order.”

The race is on now to recruit “Quants” in preference to Traders. These are young smart graduates that understand quantitative analysis and can use it to program algorithmic trading systems. In the article, “Demand for Quants Surges …” Ivey Schmerken states,

“Quants out of school just two or three years can make anywhere from $200,000 to more than $500,000 a year on Wall Street, “depending on their experience and how smart they are,” notes INET Technologies’ Long.”

When I was a lad you gave your kid a guitar and sent him off to make his fortune, then it was a tennis racket. Now it’s quantitative maths and algorithmic programming.

Just to get an idea of how big this is take a look at the list of Algorithmic Trading Service Providers. They include Goldman Sachs, J P Morgan who recently posted record profits – hmmm! Some say much of that profit was from Algorithmic Trading.

Take a look at the column “Approximate category breakdown of clients”. Mutual Funds are well represented. There’s nothing long term here. No research necessary. Just use the Algol system to game the market and hope your algol is better than the others.

No value investing, no long term strategy, nothing but trading at the speed of light.

And we thought they had learned their lesson. Your money is just cannon fodder to these “qaunt” machines spewing out millions of buy orders a millisecond.

I think the word “Investment” should be a reserved word and enshrined in the constitution of all nations to mean what it is supposed to mean. Algol Trading is not investing by any stretch of the imagination. It is trading pure and simple. If your managed fund is doing it you need to know so you can decide if that’s what you want done with your money. You may not even be asked. If you’re okay with it fine. But they have a duty of care to tell you how they are trading (not investing) your money.

As with all these systems when everyone is doing the same thing we’ll eventually have a bubble and even though there are several algorithmic services out there they will eventually become very similar as “Quants” move around for better pay and conditions and take their programming skills with them.

Hasn’t Goldman Sachs just suffered from a quant defection or a spy attack?

There are currently 48 Algorithmic Trading Service providers listed in the directory mentioned about. If Algorithmic trading already accounts for 40% of all trading on the DOW don’t you think that is a problem? The transaction count may be huge which the financial guys will tell you makes the market more liquid but, all the transactions are coming for just a few large computers located at the exchange. That’s not market liquidity and that concentration of automatic computer trading power cannot be good for “real investors”.

One very quiet morning as the trading day starts all these systems may well decide it is time to sell in unison and world markets will crash once again. Even stop losses won’t help as the market will go right through them.

Make sure you protect your nest egg – just in case 🙁

One Response to “Algorithmic Trading is Everything – Investing is Dead”

  1. […] now all the major financial companies are setting up algorithmic trading platforms. These trading platforms look for millisecond trades using millions of dollars in thousands of […]

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