Automated Trading – Friend or Foe?

The U.S. Securities and Exchange Commission and the Commodity Futures Trading Commission implicated algorithmic and high frequency trading in the May 6, 2010 Flash Crash when the Dow Jones Industrial Average suffered the largest point loss intra-day ever, to that date.  This implication has brought forth much public debate.

Automated trading or algorithmic trading is also known as black-box or algo trading. All of these types of trades use a computer program to enter trade orders. The computer actually decides on aspects of the order such as price, timing, and quantity.  This is often done without human input.

Pension funds and other buyers of large quantities, institutional traders, etc. will frequently divide large trades into smaller orders to stop the market from being impacted.  In other words, extremely large buy orders, if placed as one order can drive the price of the stock up.

This would cause some of a market order to be bought at a higher price that the first shares executed or a limit order to not be fully executed. Large buyers therefore use computer programs to place these orders so that they have more control over price of their shares.

Computers receive electronic information and can process this faster than a human, making large sellers also use them to place orders. Firms who make a market in stocks and hedge funds generally use an algorithmic trading program for this reason. This also helps to maintain a liquid market.

Opposed by human brokers and traders facing hard competition from computers, algorithmic trading has been proven to support market liquidity. Of course, the computers also bring with them the possibility of malfunction or breakdown, which could halt the market completely.

Efficiency comes with a price, the loss of human interaction.   Personal brokers feel they have an intuitive feel, or gut feel, for the market that is necessary for successful investing.

With over 70% of trades in the U.S. 2009 markets placed by black-boxes, it appears we are well on our way to having a fully automated stock market investing.  That is great for market liquidity.  Personal brokers are ready and willing to give advice and place orders for the small investor.  For the time being, everyone has an opportunity in the markets.

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