De- jargoned | Algorithm trading

Last week, the “flash crash” in the S&P CNX Nifty was much in the news. In a matter of seconds, in the middle of a regular trading day, Nifty futures crashed around 7%. In the earlier part of the trading day, Infosys Ltd stock futures crashed 20% before recovering. Recovery after such a crash typically happens soon, but investors may get jittery. Reports have suggested that this kind of movement was a result of errors in algorithm-based trading.

What is it?

It is a sophisticated system that makes use of advanced mathematical models. This kind of system is used not only in stock markets but also for currency and commodity trading. The model defines certain rules or limits on the basis of which a trade is undertaken.

What purpose does it serve?

Large lots of shares are usually purchased by breaking them into smaller lots and allowing the sophisticated algorithms to decide when the orders for these smaller lots should be placed. Instead, if a large order is placed in one go, the demand could raise the stock price by a huge margin almost immediately and that would mean the investors would also have to buy at the elevated price. Use of algorithm-based trading can avoid the above situation. Institutional investors such as insurance firms, hedge funds and pension funds trade in large volumes and algorithm-based trading is useful for them.

How can it lead to a flash crash?

Although mathematically modelled and electronically placed, the details of these orders have to be entered manually into a software program, which translates the order for the exchange. Sometimes there are input errors in the figure or a key field like a limit price gets left out. Such errors can lead to what we saw in case of the Nifty and Infosys futures last week. There can also be a technological malfunction within the algorithm that can impact the order placement. The impact is immediate but also gets corrected pretty soon.

What does it mean?

There is no real significance of such incidents on fundamental price discovery for the stock or index. Day traders can suffer if stop-loss prices get triggered, but for long-term investors, it doesn’t matter. Such things can happen and if you do witness it, do not panic.