2:45 p.m., May 6, 2010 is a date and time that will live forever in the minds of many active traders. This is the exact time of the U.S. stock market going absolutely haywire for the first time in history. Various stocks had zero bids, indexes collapsed, and mad man Jim Cramer looked like he was about to have a heart attack on live financial TV, saying, “This is not real…” while pointing and gesturing wildly at the screen. Fortunately, order was soon restored to the markets, but the exact cause of this so called “flash crash” is still debated.
Conspiracy theories, fat finger mistakes, even acts of God have been bantered about regarding the cause of the flash crash. We may never know the exact sequence of events leading to this situation, but one thing is for sure: the events of May 6, 2010 brought a spotlight of scrutiny on automated or algorithmic trading technology. The public’s interest was triggered and many started to ask, just what is automated trading and what is the power behind it?
Automated trading is the use of computers for entering and exiting trades based on various data algorithms. It can be used for high frequency trading (HFT), which is the entering and exiting of orders at a rapid pace, often much faster than a human trader’s perception. It is also used to slice and dice large orders to reduce market impact, arbitrage, market making, and even for some old time trend following type strategies. The behind the curtain structure of automated trading is really quite simple. A data provider pumps data into a strategy/execution engine resulting in an automated transaction on the exchange. Provided the correct algorithmic strategy/execution engine, profits are created until the competition figures out a way to beat you to the exchange. With automated trading accounting for over 70% of all stock market volume in 2009, a true arms war, focused on speed, is being fought in the financial markets. It’s no longer simply how well you can trade, it’s how fast your brokers infrastructure is in getting orders into the market. Speed is the true power behind automated trading.
The speed needed to compete in the new world of automated trading is measured in microseconds. Just to clarify how fast we’re really talking, order latency is described as having the speed of light as a baseline. Aggressive trading firms and cutting-edge brokers are locating their servers near or actually collocating in the same building as the exchanges to eliminate any fractional lag in data transmission. It has gone as far as collocation facilities assuring their various clients that everyone has the same length of cable as to not even provide a particular client even that small of a speed edge.
Automated trading, in all its forms, is a rapidly growing trend in the financial markets. The liquidity added by automated trading helps the entire marketplace by making it more efficient for everyone. While we may never know what, if any role, an automated trading snafu played in the May 6th market flash crash, one thing is for certain: automation has changed the battlefield of electronic trading.
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