DEFINITION of ‘Algorithm’:
An algorithm is set of rules for accomplishing a task in a certain number of steps. One common example is a recipe, which is an algorithm for preparing a meal. Algorithms are essential for computers to process information. As such, they have become central to the daily lives of humans, whether someone orders a book online, makes an airline reservation or uses a search engine.
Financial companies use algorithms in areas such as loan pricing, stock trading and asset-liability management. For example, algorithmic trading, known as “algo,” is used for deciding the timing, pricing and quantity of stock orders.
BREAKING DOWN ‘Algorithm’:
Algo trading, also known as automated trading or black-box trading, uses a computer program to buy or sell securities at a pace not possible for humans. Since prices of stocks, bonds and commodities appear in various formats online and in trading data, the process by which an algorithm digests scores of financial data becomes easy. The user of the program simply sets the parameters and gets a desired output when securities meet the trader’s criteria.
WIKIPEDIA – Algorithmic trading is a method of executing a large order (too large to fill all at once) using automated pre-programmed trading instructions accounting for variables such as time, price, and volume to send small slices of the order (child orders) out to the market over time. They were developed so that traders do not need to constantly watch a stock and repeatedly send those slices out manually. Popular “algos” include Percentage of Volume, Pegged, VWAP, TWAP, Implementation Shortfall, Target Close.
Algorithmic trading is not an attempt to make a trading profit. It is simply a way to minimise the cost, market impact and risk in execution of an order. It is widely used by investment banks, pension funds, mutual funds, and hedge funds because these institutional traders need to execute large orders in markets that cannot support all of the size at once.
The term is also used to mean automated trading system. These do indeed have the goal of making a profit. Also known as black box trading, these encompass trading strategies that are heavily reliant on complex mathematical formulas and high-speed computer programs.