The Impact of Algorithmic Trading

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The Impact of Algorithmic Trading
Atharv Tilak, Priyanshi Kejriwal, Siddharth Venkataraman, Lov Loothra, Parth Krishnan Mannadiar, Ritu Kapse and Puneeth C

Faculty Mentor Dr. Ashish Varma

Background
The stock market is a place where you can market or trade a company’s stock, which the corporation issues through shares in order to raise capital. The people who buy these shares are shareholders, and the term can refer to an individual or an organization. The stock market involves trading of bonds, which is a debt security that stipulates that the issuer of the bonds holds the holders a debt. It is exactly like a loan only that it is in form of a security. These bonds are traded over-the-counter, which means they are traded between the two parties. Instead of promising your money back, companies give a share of ownership. If there are a million shares and you own 1000, you own 0.01% of the company. The stock market is different from the stock exchange, which is primarily concerned with bringing together buyers and sellers of stocks and securities. There are two types of exchanges where stocks can be traded. There is the exchange that has a physical location where verbal trading takes place. The other type of exchange is the virtual kind where traders deal electronically through computer terminals. Computerization of the order flow in financial markets began in the early 1970s, with some landmarks being the introduction of the New York Stock Exchange’s “designated order turnaround” system (DOT, and later SuperDOT), which routed orders electronically to the proper trading post, which executed them manually. The "opening automated reporting system" (OARS) aided the specialist in determining the market clearing opening price (SOR; Smart Order Routing). Program trading is defined by the New York Stock Exchange as an order to buy or sell 15 or more stocks valued at over US$1 million total. In practice this means that all program trades are entered with the aid of a computer. In the 1980s program trading became widely used in trading between the S&P500 equity and futures markets. In stock index arbitrage a trader buys (or sells) a stock index futures contract such as the S&P 500 futures and sells (or buys) a portfolio of up to 500 stocks (can be a much smaller representative subset) at the NYSE matched against the futures trade. The program trade at the NYSE would be pre-programmed into a computer to enter the order automatically into the NYSE’s electronic order routing system at a time when the futures price and the stock index were far enough apart to make a profit. At about the same time portfolio insurance was designed to create a synthetic put option on a stock portfolio by dynamically trading stock index futures according to a computer model based on the Black–Scholes option pricing model. Both strategies, often simply lumped together as "program trading", were blamed by many people (for example by the Brady report) for exacerbating or even starting the 1987 stock

market crash. Yet the impact of computer driven trading on stock market crashes is unclear and widely discussed in the academic community. Financial markets with fully electronic execution and similar electronic communication networks developed in the late 1980s and 1990s. In the U.S., decimalization, which changed the minimum tick size from 1/16 of a dollar (US$0.0625) to US$0.01 per share, may have encouraged algorithmic trading as it changed the market microstructure by permitting smaller differences between the bid and offer prices, decreasing the market-makers' trading advantage, thus increasing market liquidity. This increased market liquidity led to institutional traders splitting up orders according to computer algorithms so they could execute orders at a better average price. These average price benchmarks are measured and calculated by computers by applying the time-weighted average price or more usually by the volume-weighted average price. A...
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