Wednesday, November 08, 2006

Algorithmic trading

By definition an algorithm is simply a rule set, instruction set, or an established procedure for solving a problem in a limited number of steps.

Algorithmic trading is a marketing buzz phrase for an idea that has been with us for decades. If you want to try algorithmic trading check here; if you want to learn more, read on.

Why call it algorithmic trading? Because it sounds sophisticated. Non-math or non-computer types are unlikely to understand the phrase - so brokers and salesmen sound competent when they say it.

The odds are you say algorithmic trading occasionally so you sound knowledgeable too. I am using it in much the same way right now. The key is that algorithmic trading is not new, it has had its components jiggled a bit, but it is still just speculating rules directly managed by a computer.

In the past we used marketing phrases that denoted the same idea - program trading, computerized trading, portfolio insurance, scientific investing, and others. Once they were too well known, or discredited, they dropped from the investment lexicon.

So, exactly what is algorithmic trading and why are investors excited by it?

It is the, as yet unfulfilled, promise to make everyone's dream of automatic money making come true. In prior decades it was touted under those other names; names like portfolio insurance, computerized trading tools that were supposed to automatically gain profits and protect wealth.

Portfolio insurance blew up and took the market with it - they had the wrong algorithm. Today algorithmic trading is bigger than portfolio insurance, and we don't yet know why it will fail. It has a larger share of the market than prior computerized trading tools, but in essence it is still the same idea.

As an aside, what the exchanges and the press will say was the cause for market failure is unlikely to be the real reason.

Ah, I hear the common man say - "but we are more sophisticated now." That's true, but we also thought we were sophisticated scientific traders when we believed portfolio insurance would work. It did for a while, then once it reached a certain size and event it imploded.

The most accurate pricing mechanism is still open-outcry, the sort of trading that transpires on the floor of commodity exchanges.

We are still as ignorant as prior generations - wait ten years and read what we will write regarding what we think works now. We will then claim our new phrase is real sophistication.

In brief: life is not linear. computerized trading assumes that life can be captured in a mathematical formula and emulated. Somehow they can never allow for lemmings.

The following is adapted from a story at Bastiat Free University, who adapted it from somewhere else. I'm sure we could find the original source if we just had the right algorithm.

An investment quantitative analyst came to a horse handicapper and said he had found a mathematically sound way to predict the winner in horse races. The gambler became excited; no more reading stats, comparing jockeys, watching weather, etc. In other words, winning could be done with a sophisticated formula and would no longer be hard work and risk. The bookie took the algorithmic trading quant off to one side and asked for a hint to the process. The Nobel prize winning genius said:

" well, first we assume all the horses are ellipses."


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Letting the computers do the trading is a mistake.

1:59 PM  

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