The role of Algorithm in a person’s life is too substantial to be ignored. From a simple coffee-making machine to the music system in his car, from elevators to search engine like Google, all are governed by a set of logical instructions – Algorithms or Algos, which enable them to respond to a person’s specific requirement.
With the advent of internet, Algorithmic potential has been unleashed in its truest form. Defining trends, identifying preferences through social media and targeting relevant groups with tailor-made services have been possible through sophisticated Algorithms put in place.
Of course, with all the technological advancement, stock markets have been on the forefront of adapting to the riveting world of Algorithms. Algorithmic Trading has gradually become the most preferred way to trade on the bourses, with an estimated 80% of the total volumes of the Wall Street. Institutional investors, hedge funds and large financial brokerage houses have switched to Algo-trading to stay competitive, cost-effective and cater to their clientele.
So, what exactly is Algorithmic Trading or “Black Box Trading”? Does being a successful Algo Trader carries prerequisites like expert programming skills? What is the investment required for Algo trading desk to be set up? These were some of the questions that I pondered upon, while deciding a career switch in favour of Algorithmic trading.
Full Disclosure: I am a complete novice to Algorithmic Trading. To test waters, I joined a few forums on quantitative finance and Algo trading, but the discussions there only reaffirmed my inadequate knowledge about the subject. So, I started talking to some experts in the field to understand its pros and cons. I must confess that this is the safest way to explore the myth around the utility of Algorithmic trading.
In the process of satiating my knowledge appetite, I explored multiple sources with a few providing genuine guidance, while others offering marketing gimmicks. My quest finally ended after a freewheeling chat with some of the Quantitative Analysts and High Frequency Trading experts at iRage Capital, one of the top Algorithmic trading firms in India. iRage Capital was started in 2009 and has been a known name in the Algorithmic Trading domain in Indian Markets ever since.
Here are some excerpts from the conversation:
On how to get started
Me: The world of Algorithmic Trading still remains an enigma to a lot of people, probably due to high quantitative skills involved. Can you take us through the behind-the-scenes setup of an Algo desk?
Expert: I think the enigma is over-stating it. Algorithmic Trading is a fairly simple process of using a set of instructions to place order of buying or selling scrip with volumes and speed impossible for a human being. The set of instructions are based on various market metrics like price, time, volume and any other user preference. The good part about Algo trading is that it eliminates human intervention thereby making trading sans emotions and intuition.
A typical Algorithmic system’s architecture entails three primary components – (a) Market Data Handler (b) Strategy Module (c) Order Router. The market data handler, as the name suggests, receives the market data and stores it. Strategies for trading, in a mathematical model, are fed to the strategy module. It also serves as an interface between the market and a trader. Order Router or manager sends the order back to the exchange for buy/sell.
To set up an Algo desk, as a broker you need to identify your co-location to place the servers with close proximity of the exchange, feed in your strategies to your system after having it backtested and authenticated, have a good internet connection, and I think you are good to go!
Me: Ok. That does seem not so “mysterious” any more. Now, given that I have little background of Algorithmic Trading or Quantitative Finance, what are the steps would you suggest to venture into the field?
Expert: Well, first and the most important step is to build a solid base. Learn some programming skills and get a grip of the markets. Being good with numbers always helps. Begin by exploring core subjects like statistics and econometrics. Some books like Quantitative Trading by Ernest Chan or Trading & Exchanges by Larry Harris can elaborate on setting up a “proper” Algorithmic trading system. When you are through with the above-mentioned steps, get your hands dirty in strategy building, modelling techniques, and statistical tools. Get a hang of various trading strategy paradigms, like statistical arbitrages, execution strategies, bid-ask spread. There are a few free courses available online on Udemy and Udacity which are quite good to test waters. There are other paid and advanced courses available for serious learners.
Me: Great! You talked about the programming languages. Which are the commonly used ones employed by the traders?
Expert: C++ remains the most preferred language as far as High Frequency Trading (HFT) goes. Reason being that memory leaks and related errors are far less in C++ as compared to other languages. Python has come up in a major way for coding strategies as well as back testing, because it is easier to master, and is backed by good scientific libraries like Numpy. A number of forums today discuss investing and trading strategies coded on Python programmes.
Is Algorithmic Trading only for the Institutional Investors
Me: How is the retail participation in Algorithmic trading? I am assuming that setting up cost is too high for them to afford a system.
Expert: The setting up cost is definitely on the higher side, from a traditional trading terminal. Obtaining a co-location can be an expensive affair. According to recent statistics, nearly 70-80% trade on Wall Street is done using Algos, chiefly by large institutional investors and hedge funds. However, the scene for retail participants is evolving with the offering of web-based platforms. For someone who is not too concerned regarding latency, its works like a charm. Other than that, firms like Interactive Brokers provide retail clients with API, and packages so that traders can code their strategies and trade. Once you get a hang of it, it is like a simple Gmail account. You log in to your account, test your strategy, perform back testing, and after optimization, trade in live markets. Paper trading or testing on simulator is also highly recommended.
Me: How is the ecosystem for Algorithmic Trading in India? Are companies readily opting for Algorithmic trading given its niche category and involvement of highly skilled practitioners?
Expert: Algorithmic Trading was allowed in India by SEBI in 2008. In a span of 8 years, nearly 50% or of the trade by volume or may be even more than that is Algo-based. That speaks for its popularity. Indian bourses have adapted to the change very well, with steady increase in the active participants. Both FIIs and domestic funds use the Algo route to place orders.
A peek into the future
Me: How does the global future look like?
Expert: Very promising actually. It is clear that automation is the future that is driving the world. Be it in any field, automation is making a tectonic shift from a traditional path, and the same applies to stock markets. In US markets, 70-80% of the exchange volumes is happening through automated systems. Emerging markets like India are witnessing exponential growth in the domain. Of course, the markets are maturing every day, so trading costs would decrease after a certain point. Case in point: Automobile Industry, where after the introduction of robots, it was initially thought that the industry would be unsustainable due to high capital cost.
Me: Since you have been involved in Algorithmic trading for a long time, can you list some of the biggest lessons you have learned?
Expert: There are quite a few actually. The most important one is that it is just not enough to have a good trading strategy, but also to have a competitive edge. It can range from having innovative ideas which disrupt to having a low brokerage or the kind of markets you have access to, but you have to have a killer proposition if you plan to be successful. Treat this as any regular business, where you have to develop a strategy to outwit the competition. It is important for someone starting new to have the nuances of the trade figured out.
Me: Cool. Thanks for those ideas. They really helped in dispelling several doubts regarding Algorithmic Trading. Can you tell me what should be my next step if I want to understand more about this field?
Expert: The best way is to find experts and domain authorities to talk and discuss your doubts. Try out freely available tools and resources on the internet. Be prepared to embrace new knowledge and develop new skill sets!
To talk and discuss with a domain authority, you can join an “Informative session on Algorithmic Trading” with Mr. Nitesh Khandelwal, the Co-Founder at iRage Capital Advisory Pvt Ltd, the leading Algorithmic and High Frequency Trading firm in India. With a rich experience of global markets and business environment, Nitesh has spoken in various South East Asian exchanges about Algorithmic Trading.