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Capital Markets

Secrets of the algorithm

Algorithmic trading is transforming the secondary equities market and the brokerage business. Its growth seems inevitable, but what will the consequences be? Peter Koh reports.

ALGORITHMIC TRADING’S IMPACT on the cash equities market has been huge, especially considering the relatively small proportion of the total trading volume for which it accounts. Although there is much confusion about the technique, most market participants seem to agree that it will be used increasingly frequently. Financial services consultancy Celent estimates that by 2008 up to 25% of all trades by volume will be executed using an algorithm, up from about 18% today.

Since algorithmic trading began to take off as an execution tool in 2000, the average trade size on the London Stock Exchange has fallen from £60,000 to just over £20,000 ($34,000). The fall in the average trade size is widely attributed to the use of algorithms because one of the most basic things they all do, regardless of the particular trading strategy, is to divide an order into many smaller ones, as a small trade is less likely to have an impact on the market price than a large one. Although to an extent this is also what any human trader concerned with market impact does, computer algorithms divide orders into many smaller trades than any human trader would ever find it efficient to do.

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