The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

TRADING MECHANICS

The equity markets have been characterized by major innovations in trading by investors. Specifically, algorithmic trading (also called algo trading and black box trading) involves using computer-based algorithms to determine the timing, pricing, and quantities of trades. Algorithmic trading is often used by institutions to divide single large orders into many small orders to reduce market impact and disguise their trades. One type of algorithmic trading is high-frequency trading (HFT), in which computers use information received electronically to generate orders without human input. There are many uses for this type of trading, including market-making, arbitrage and simply filling orders. HFT is estimated to account for over 70% of stock trading in the United States in 2010. A subset of HFT is flash trading in which traders are permitted, for a fee, to view incoming buy or sell orders for a brief amount of time (often 30 milliseconds) before they are exposed to the entire market.

There have been two dramatic effects of algorithmic trading. First, fast computers and advanced algorithms have significantly reduced the average trade sizes on exchanges. Specifically, the average trade size of a NYSE-listed stock declined from 724 shares in 2005 to 268 shares in 2009. Second, the time it takes to complete a trade, called latency, has declined significantly. Trading times are measured in milliseconds and even microseconds (one-thousandth and one-millionth of a ...