Chapter 3 - The Growth of Program and Algorithmic Trading

Abstract

This chapter presents a discussion on the growth of program trading and algorithmic trading in the U.S. securities market. Program trading volume, also known as portfolio trading, has increased dramatically in the past several years. The New York Stock Exchange (NYSE) reports that in 2000, 22% of all trading on the Big Board was executed via programs up from 11.6% in 1995, and in 2004, that number has increased to 50.6%. Program trades provide money managers with the ability to execute a basket of stocks without being subject to the variance of each individual stock. The portfolio can benefit from diversification where the risk of the whole can be smaller than the risk of the sum of the parts. It gives the trader the ability to focus on controlling the market and sector risk while seeking to minimize the market impact of the whole portfolio. The greater availability of technology and the increasing use of modern portfolio techniques are driving the recent growth in program trading. Program trading also has the ability to handle the complexity that results from intraday market volatility. Program trade can be done considerably faster than if done via individual block trades and thus, its efficient use can result in time saving that can in turn result in lower opportunity cost and lower total cost. Most of the growth in algorithmic trading has been driven by the sell side and hedge funds. At the end of 2004, 200 million dollars were spent on different IT components that make up algorithmic trading services. Order Management Systems accounted for over 60% of that total spending. By 2008, IT spending on algorithmic trading is expected to reach over 300 million dollars.