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Anthony Calvo

Professor Dietel-McLaughlin

WR 13300

November 14, 2014

Automated Trading: What This Trend Could Mean for the Everyday Investor

Recent trends in communication and technology are shaping the way business is held

everyday. It is believed by many investors that a stocks conditions like volume, 52 week
moving average, standard deviation, and mass index are a good indication as to what the stock
will do in the future. Overtime analyst and traders have done their research and found trends like
a cup with handle or Bollinger bands that generally indicate how the stock will perform.
However, these trends are not always immediately apparent and even if they are can be difficult
to calculate in time to act. Improvements in chip manufacturing, computer programming, and
stock technical analysis in the last 15 years have led more investors to try implementing
automated trading in order to combat the limitations, specifically time limitations, of using stock
trends. The theory behind automated trading first gained notable attention when Harry
Markowitz, University of Chicago student, wrote his dissertation on applying mathematical
concepts to the stock market. This set the path for IBM researchers in 2001 to write a paper on
how the mathematical concepts could be integrated with computing in order to make more
effective trades over the long term (Read). Automated trading uses computer programs to buy
and trade stocks the second certain conditions are met. This strategy allows for virtually
instantaneous transaction times. Investing firms like Goldman Sachs, Knight Capital, and Argo
have begun implementing such strategies and are finding success. However, only a small
minority of everyday investors have been able to implement these strategies. The viability of

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automated trading for the everyday investor remains largely questionable. The majority of
everyday investors have the constraint of a lack of education to be proliferate in both finance and
computer programming. However, if the everyday investor is willing to learn the skills required
to implement automated programming, they could reap huge benefits. The advantages include
faster trading times, unemotional decision making and passive trading( trading away from the
computer). The way automated trading will effect the market is still unknown, but has the
potential to be everyday investors greatest strength or weakness. Opinions on the viability of
automated trading vary from professional to professional, especially due to recent failures, but
several important sources believe the individual investor can use this situation to thrive in the
automated market.

Emotional responses to situations in the stock market often lead investors to make rash

uninformed decisions. Automated trading helps combat this by breaking down investment to an
objective form. Dr. Durenard, Phd in Mathematics from Harvard, believes objectivity is the
surest way to make long term gains in an ever revolutionizing market. There are two options
discretionary and systematic trading. Systematic trading accepts the idea that there are rules
governing trading strategy and applies those rules to absolutely avoiding human emotion.
Discretionary trading can still be fairly objective looking at certain statistical values, but still
factors in an investors view of the world and state of mind and other factors that cannot be
quantified by computers. In using automated trading systems Durenard disregards discretionary
trading as a whole and focuses solely on systematic trading (automated) with a focus on
institutional trading because he believes it is the most objective. His reasoning behind this is
primarily that automated trading improves trade execution times and eliminates human emotions
that can lead to rash decisions. Then Durenard goes on to introduce back testing, data

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persistence, and fault tolerant systems (Durenard 2-6). Automated trading is bound by the theory
that the market can be predicted the majority of the time based upon trends and certain
conditions. These trends range from incredibly basic to stupendously advanced creating a large
trading gap between the institutional investor, a professional, and the everyday investor.
Durenard focuses primarily on these advanced techniques and strategies as he writes towards
large institutions. This leaves the everyday investors with a lack of expertise in implementing
complex strategies compared to institutions. Although this is true the benefits of using trends,
even basic ones, to objectify the market still hold true for the everyday investor. Why are these
trends so effective compared to discretionary trading? It is because of the irrationality of
investors due to emotion, that is often over looked. Several firms and researchers focused on
behavioral finance like MarketPsy have eliminated the idea that investors are rational, and
actually try to judge their irrationality. This is because when people are deeply gloomy about a
stock, it is time to buy; when they are raving about its brilliance, sell (Mackintosh). Many
investors do act incredibly irrationally and this gives an opportunity for institutional investors to
make more profits as Mackintosh states. Many investors become scared when stocks crash and
attempt to sell in order to retain the little money they have left, but this does not make sense
because the market has ups and lows. The market will eventually come back. In order to
physically make money investors need to buy lower and sell high, which sounds fairly obvious,
but in the heat of the moment many investors tend to act irrationally. These investors
unfortunately often tend to be everyday investors who have not been formally educated in
finance and therefore do not know the markets general trends. In implementing automated
trading everyday investors are able to eliminate most if not all of their irrational decisions in the

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heat of the moment. Objectivity also allows for faster trading times because it enables data to be
quickly compiled and calculated to make a decision.

Time plays a crucial role in the market as seconds end even milliseconds can sometimes

make thousands of dollars of difference. It is in the interest of every investor to optimizing

trading times in order to maximize profits and minimize losses. Mark Buchanan is adamant about
the importance of trading times. Buchanan discusses specifically trade execution times. It is also
crucial to trade rapidly, before the competition can get in on the action. Because of the finite
speed of light, trading speed depends on where you are sitting(Buchanan). Buchanan is
absolutely right in his assertion because the market and its brokers factor in only which trade is
in first, and completely disregards how close the second trade is. He reports on how location is
key in trade time. Some investing firms are considering moving to potentially remote locations in
order to attain milliseconds of time decreased in execution times. Location helps individual
investors to a considerable to degree because many everyday working people have much less
internet traffic in their communities than big businesses in the city. Although the potential for
institutions to move to locations for faster trading times exists, it is highly implausible. As it is
difficult to move an entire corporation to a remote location without losing employees and capital
(money) . Individuals on the other hand are much more free to move geographically, which can
give everyday investors those extra few milliseconds they need. Other than location there are
several factors that determine trading times, specially some that can benefit the everyday investor
in particular. Nuti, Mirghaemi, Yingsaeree ( computing Phd students) and Treleaven (Professor
of computational finance at University College London) discuss the methods by which
investment firms must place their order. Investment firms trade in such a high quantities that their
trades can actually be significant to the volume (amount of stock bought or sold in a given

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amount of time). The more people buying the higher the price will go and the more people
selling the lower the price will go. Investment firms must balance between risk, trading time, and
market impact. The methods vary between placing one very big order and multiple small orders
and the type of order(Nutti et al 67). The automated trading software will take several more
milliseconds to take these factors into account before finally ordering the trade. Once the trade is
ordered it will not be fully executed until someone one else places the opposite trade. All of this
adds up to make a considerable time difference. The everyday investor does not trade in such
high quantities and therefore does not have to wait for as many opposite trade orders.

Overall between the advantages of lower quantities of trade and location the every day

trader gains a considerable advantage over large institutions. However, large institutions can also
afford larger servers and better internet connection giving them a bit more speed in sending trade
orders. Institutions are also able to afford faster computers than the every day investor making
automated trading programs run faster. However, these two factors in combination still leave the
everyday investor with a significant time advantage.

This time difference can often lead to considerably easy trading strategies. David

Leinweber ( MIT computer science graduate and PhD in Applied Math from Harvard), and
Jacob Sisk explore event driven trading which ultimately stems form the news. The peer
reviewed journal article gives several of the countless examples of times when the market is
directly affected by news. The information revolution of trading and news due to the emergence
of the internet and electronic trading has allowed for both to be accessible almost
instantaneously. In the past before news was publicly announced it would be factored into stock
prices, but now the immediacy of both trading and news has made those efforts futile
(Leinweber). Major sources like the government, SEC, and corporations are ultimately the most

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credible in regard to the stock market, but also give investors the least amount of time to act
upon and therefore limit potential profits. In the past news was limited to many of these major
sources because unless one physically witnessed a report one would have to wait until the major
news story came out in order to act, but by then it would be too late. However, with the recent
emergence of social media in all corners of the globe videos, tweets, audio, and images are all
uploaded to the internet as they are happening. The idea of finding news stories before they hit
major coerces sounds great, but how could an investor find sources relevant to his own
investments? Even if the sources could be found would this place too much significance on
something as frivolous as a tweet? The solution ultimately lies behind automated trading. Some
trading programs take into account not only financial statistics and trends, but also news. These
programs search multitudes of blogs and social media websites, such as Instagram, Twitter, and
Facebook. News trading takes more than just a single user into account, but can quickly compile
what thousands of people are saying about a particular subject. As a hypothetical example, say
suddenly hundreds of tweeters begin to rave on about the how good coffee goes with donuts. It
seems to be absolutely frivolous conversation, but a smart investor would then look to buy a
company that sells coffee and donuts, such as Dunkin Donuts. This method of using automated
trading helps keep investors constantly aware of what the situation is and how to best go about
responding to it. This helps both institutions and everyday traders more or less equally, but none
the less is still an advantage.

Another major advantage automated trading can have for the everyday investor is the

ability to trade during the day with out actively monitoring the markets move. A traders guide
to spread betting says You should approach day trading as a business really - it is a demanding
profession and if you do not have the time to day trade you should not trade at all(How Much

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Time I Need to Dedicate to Trading). Most every day investors have day jobs and unless they
trade while their supposed to be working, they are forced to leave trading until after hours. This
is a huge disadvantage because institutional investors are able to constantly watch each stock and
then place orders at the perfect price. This disadvantage forces every day investors to respond
somehow. But how could they even respond to the situation without quitting their jobs?
Automated trading could help bridge this gap by finally allowing the everyday investor to make
trades based upon intraday movements of the market. The everyday investor is essentially trying
to objectively categorize the situation in order to respond despite the constraints of an every day
job. This seems beautiful on paper, but poses several problems especially for the individual
investor because of malfunctions.

Automated trading malfunctions pose a serious threat to the viability of automated

trading not only for institutions, but also for the individual. The two main examples of this are
the flash crash of 2010 and the error that almost led to Knight Capitals bankruptcy. On August 1,
2011 Knight capital sent out a series of unintended trades due to an automated trading
malfunction. The company faced possible bankruptcy through the week after as they pleaded
within Securities and Exchange Commission (SEC), but found them unwilling to bail out Knight
Capital. Ultimately by the end of the week Knight Capital was bailed out by several author
investment firms like Jefferies Group, Blackstone, GETCO, and TD Ameritrade(Lazarus of
Wall Street). The possible collapse of Knight Capital was certainly almost tragic, but nothing
compared to the flash crash of 2010. Algorithmic Trading explains how the use of automated
trading is suspected by the SEC to be the reason behind a loss of 600 billion dollars in the market
value of U.S. Corporate stocks in a matter of five minutes. The market quickly recovered
afterwards in part due to automated trading, but the occurrence is still significant. Basically what

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occurred was one investor placed several trade orders in his trading program causing a small loss
in stock price. Several institutions however had sell orders in via automated trading that triggered
if the stock price dropped to that point. Therefore, in the blink of an eye, the market came
crashing down until investors realized what had occurred and repurchased stock, restoring losses.
In the scheme of the market as a whole the use of automated trading among individuals is not as
potentially threatening. If one investors program malfunctions the entire market will not crash
and most likely it will not even make a difference in the stocks price. Although this is an
advantage of automated trading for the individual compared to the institution it still is a
considerable disadvantage of the viability of automated trading as a whole to an extent.
Automated trading is still relatively new and definitely still in its beginnings. Automated trading
may have this disadvantage now, but throughout time it will develop to avoid malfunctions.
Ultimately malfunctions are simply a disconcerting road block on the path to automatization. The
actions of the companies bailing out Knight Capital is proof of this. Those companies bailed out
Knight Capital because they think automated trading is not just a fad in trading strategies, but the
beginning of a new market transition. The severe and pertinent malfunctions of automated
trading have also bounced back relatively quickly therefore having very little long term affect on
the market.

The marketed transition to automated trading can have significant implications on the

individual (everyday) investor. One major subset of automated trading is high frequency trading.
High frequency trading focuses on trading a lot of stock and holding it for an abysmally small
amount of time and then selling it for tiny profits. However, this is done on a large scale and
continuously so the tiny profits add up rather quickly to turn into long term gains. This type of
trading increases the volatility of the market as it often attempts to buy stocks going up and sell

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stocks going down(Zubulake 6-10). Stock volatility is to most investors a disadvantage except
high frequency trading investors, who get get more profits from the large price drops and rises.
This is particularly bad for individual investors because it means a lot of short term losses. The
individual investor does not have the same amount of capital as an institution. It is generally
accepted that the market rises in the long term, but it can sustain large losses along the way. It
can be difficult for individual investors to sustain these losses because they sometimes need the
money and are forced to take it out of the market on the low side. In contrast, institutions
generally invest more money once the market has fallen to make larger profits when the market
goes back up. The volatility of high frequency trading is what the SEC suspects to have been a
major factor in the flash crash of 2010. However, the market was slowly becoming more volatile
in 2007 and 2008, before high frequency trading had become prominent. High frequency trading
has increased liquidity and now provides the bulk of the markets liquidity (High-frequency
trading 'improves market quality). Liquidity is how readily investments can be converted into
currency. In trading so many shares of stock so rapidly high frequency trading gives traders
someone to trade with. This is an important advantage for the individual investor because people
often need to turn their investments into cash to pay for their personal needs. To demonstrate
more clearly when a buy order of 100 shares is, put in someone else must be selling 100 shares at
the same price in order for the transaction to be completed. High frequency traders provide the
market with constant opposite trades, resulting in increased liquidity (conversion from stock to
currency).

Automated trading is definitely a viable option for the every day investor. The objectivity

of using automated trading enables institutions and everyday investors alike to eliminate trades
based on emotion and decrease trade order times. Although it is to the benefit of both parties the

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trading times of individual investors are decreased further than that of institutions because of
location and the fact everyday investors trade less stock per transaction. In addition individuals
also benefit from news based trading by making trades based upon events before they are
factored into the price. Despite the potential for malfunctions in automated based trading, it does
not discredit its viability because malfunctions are temporary. As the technology strengthens and
investors are more trained to use it malfunctions will eventually disappear altogether or be
reduced to an insignificant amount. Automated trading could have significant implications in the
future evolution of the market, specifically due to high frequency trading. High frequency
trading increases volatility, but provides liquidity which is ultimately more of an advantage to the
everyday investor compared to the disadvantage of increased volatility. The only way every day
investors can keep up with the advancing financial technology is by implementing automated
trading to help close the gap between themselves and institutions.

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Works Cited

Brogaard, Jonathan. "High Frequency Trading and Volatility." SSRN Working Paper Series
(2012)Print.

Buchanan, Mark. "It's Location , Location , Location for Automated Trading." New Scientist
November 6 2010Print.

Chan, Ernie. Wiley Trading : Algorithmic Trading : Winning Strategies and their Rationale.
Somerset, NJ, USA: John Wiley & Sons, 2013. Web.

Durenard, Eugene A. Wiley Finance : Professional Automated Trading : Theory and Practice.
Somerset, NJ, USA: John Wiley & Sons, 2013. Web.

"How much Time do I need to Dedicate to Trading?" Financial Spread Betting - A Traders
Guide.Web. <http://www.financial-spread-betting.com/Time-dedicated-trading.html>.

The Lazarus of Wall Street; Automated Trading. 404 Vol. , 2012. Print.

Leinweber, D., and J. Sisk. "Event-Driven Trading and the "New News"." JOURNAL OF
PORTFOLIO MANAGEMENT 38.1 (2011): 110,+. Print.

Mackintosh, James. Decoding the Psychology of Trading., 2010. Print.

Madhavan, Ananth. "Discussion." Journal of Finance 56.4 (2001): 1485-8. Print.

Nuti, G., et al. "Algorithmic Trading." Computer 44.11 (2011): 61-9. Print.

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Read, Colin. "History of Algorithmic Trading Shows Promise and Perils." BloombergView.com.
august/8/2012 2012.Web. <http://www.bloombergview.com/articles/2012-08-08/history-ofalgorithmic-trading-shows-promise-and-perils>.

Rodriguez, E., et al. "US Stock Market Efficiency Over Weekly, Monthly, Quarterly and Yearly
Time Scales." PHYSICA A-STATISTICAL MECHANICS AND ITS APPLICATIONS 413
(2014): 554-64. Print.

Zubulake, Paul, and Sang Lee. High Frequency Game Changer : How Automated Trading
Strategies have Revolutionized the Markets. Hoboken, NJ, USA: John Wiley & Sons, 2011.
Web.

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