Does Systematic Trading Help or Hinder the Financial Markets?
Systematic trading, also known as algorithmic trading is an automated style of trading using computer generated instructions. This type of trading style uses electronic platforms to initiate positions within the financial markets. Algorithms execute instructions which include specific price levels along with the quantity of the security needed to execute a transaction. Once a trade is on the books, the system continues to monitor the position automatically managing the risk of a portfolio.
Systematic trading is employed by large institutional investors along with hedge funds who generate profits and provide liquidity. Although large financial institutions use systematic trading to increase profits their main goal is to provide liquidity to their buy side clients.
High Frequency Trading
High frequency trading is a category of systematic trading which generates thousands or transactions within a short period of time. High frequency trading strategies utilize systems by making research driven investment decisions to initiate positions based on information that is received electronically.
Many times the investment decision is based on electronic information that is formulated prior to an individual’s ability to form a decision on a piece of new information. At the heart of high frequency trading is information arbitrage which allows a machine to process information faster than a human being.
High frequency trading has changed the dynamic of the capital markets both in positive and negative ways. The increasing computer capacity has created fast markets which can generate significant volatility especially if a liquidity provider stops providing what is considered average liquidity.
The time horizon that a portfolio manager will hold onto positions during a high frequency program can range based on the goal of the program. Position taken by hedge funds may be held for only seconds, or even only fractions of a second. This style of trading requires fast and stable server processing power, and constant monitoring of speed performance.
Market participants have already witness some of the damage high frequency trading can cause when liquidity providers exit markets quickly. The May 6, 2010 Flash Crash, pushed the Dow Industrial average lower by approximately 1,000 points within a quarter hour period. High frequency liquidity providers were found to have withdrawn from the market, creating a vacuum of liquidity.
Systematic trading is generally driven by research which is usually formula based. Quantitative analysts will use mathematical programs to back test specific securities. Statistically based results are then used to determine the most efficient risk adjusted returns which are then used in a systematic trading program. Systematic trading has blossomed over the past 20-year and should continue to garner more attention as markets expand across the globe.