An automated trading system (ATS), a subset of algorithmic trading, uses a computer program to create buy and sell orders and automatically submits the orders to a market center or exchange. The computer program will automatically generate orders based on predefined set of rules using a

trading strategy In finance, a trading strategy is a fixed plan that is designed to achieve a profitable return by going long or short in markets. The difference between short trading and long-term investing is in the opposite approach and principles. Going shor ...

which is based on

technical analysis In finance, technical analysis is an analysis methodology for analysing and forecasting the direction of prices through the study of past market data, primarily price and volume. As a type of active management, it stands in contradiction to ...

, advanced statistical and mathematical computations or input from other electronic sources. * These automated trading systems are mostly employed by

investment bank Investment is traditionally defined as the "commitment of resources into something expected to gain value over time". If an investment involves money, then it can be defined as a "commitment of money to receive more money later". From a broade ...

s or

hedge fund A hedge fund is a Pooling (resource management), pooled investment fund that holds Market liquidity, liquid assets and that makes use of complex trader (finance), trading and risk management techniques to aim to improve investment performance and ...

s, but are also available to private investors using simple online tools. An estimated 70% to 80% of all market transactions are carried out through automated trading software, in contrast to manual trades. Automated trading systems are often used with electronic trading in automated market centers, including electronic communication networks, "

dark pool In finance, a dark pool (also black pool) is a private forum ( alternative trading system or ATS) for trading securities, derivatives, and other financial instruments.electronic trading platforms can execute repetitive tasks at speeds orders of magnitude greater than any human equivalent. Traditional risk controls and safeguards that relied on human judgment are not appropriate for automated trading and this has caused issues such as the 2010 Flash Crash. New controls such as trading curbs or 'circuit breakers' have been put in place in some electronic markets to deal with automated trading systems.

Mechanism

The automated trading system determines whether an order should be submitted based on, for example, the current market price of an option and theoretical buy and sell prices. The theoretical buy and sell prices are derived from, among other things, the current market price of the security underlying the option. A look-up table stores a range of theoretical buy and sell prices for a given range of current market price of the underlying security. Accordingly, as the price of the underlying security changes, a new theoretical price may be indexed in the look-up table, thereby avoiding calculations that would otherwise slow automated trading decisions. A distributed processing on-line automated trading system uses structured messages to represent each stage in the negotiation between a market maker (quoter) and a potential buyer or seller (requestor).

Strategies

Trend following Trend following or trend trading is a trading strategy according to which one should buy an asset when its price trend goes up, and sell when its trend goes down, expecting price movements to continue. There are a number of different techniques, ...

Trend following is a trading strategy that bases buying and selling decisions on observable market trends. For years, various forms of trend following have emerged, like the Turtle Trader software program. Unlike financial forecasting, this strategy does not predict market movements. Instead, it identifies a trend early in the day and then trades automatically according to a predefined strategy, regardless of directional shifts. Trend following gained popularity among speculators, though remains reliant on manual human judgment to configure trading rules and entry/exit conditions. Finding the optimal initial strategy is essential. Trend following is limited by market volatility and the difficulty of accurately identifying trends. For example, the following formula could be used for trend following strategy: :"Consider a complete probability space (Ω, F, P). Let

S_r

denote the stock price at time

r

satisfying the equation :

dS_r = S_r mu (\alpha _r)dr + \sigma dB_r

S_t = X,

t \leq r \leq T < \infty

, :where

\alpha _r \in \

is a two-state Markov-Chain,

\mu (i) \equiv \mu _i

is the expected return rate in regime

i = 1,2, \sigma > 0

is the constant volatility,

B_r

is a standard

Brownian motion Brownian motion is the random motion of particles suspended in a medium (a liquid or a gas). The traditional mathematical formulation of Brownian motion is that of the Wiener process, which is often called Brownian motion, even in mathematical ...

, and

t

and

T

are the initial and terminal times, respectively". * Volume-weighted average price According to Volume-weighted average price Wikipedia page, VWAP is calculated using the following formula: ":

P_ = \frac \,

where: :

P_

is Volume Weighted Average Price; :

P_j

is price of trade

j

; :

Q_j

is quantity of trade

j

; :

j

is each individual trade that takes place over the defined period of time, excluding cross trades and basket cross trades". * Mean reversion (finance) "A continuous mean-reverting time series can be represented by an Ornstein-Uhlenbeck stochastic differential equation: :

dx_t = \theta(\mu -x_t)dt + \sigma dW_t

Where

\theta

is the rate of reversion to the mean,

\mu

is the mean value of the process,

\sigma

is the variance of the process and

W_t

is a

Wiener Process In mathematics, the Wiener process (or Brownian motion, due to its historical connection with Brownian motion, the physical process of the same name) is a real-valued continuous-time stochastic process discovered by Norbert Wiener. It is one o ...

Brownian Motion Brownian motion is the random motion of particles suspended in a medium (a liquid or a gas). The traditional mathematical formulation of Brownian motion is that of the Wiener process, which is often called Brownian motion, even in mathematical ...

History

The concept of automated trading system was first introduced by Richard Donchian in 1949 when he used a set of rules to buy and sell the funds. Donchian proposed a novel concept in which trades would be initiated autonomously in response to the fulfillment of predetermined market conditions. Due to the absence of advanced technology at the time, Donchian's staff was obligated to perform manual market charting and assess the suitability of executing rule-based trades. Although this laborious procedure was susceptible to human error, it established the foundation for the subsequent development of transacting financial assets. Then, in the 1980s, the concept of rule based trading (

trend following Trend following or trend trading is a trading strategy according to which one should buy an asset when its price trend goes up, and sell when its trend goes down, expecting price movements to continue. There are a number of different techniques, ...

) became more popular when famous traders like John Henry began to use such strategies. In the mid 1990s, some models were available for purchase. Also, improvements in technology increased the accessibility for retail investors. Later, Justin-Niall Swart employed a Donchian channel-based trend-following trading method for portfolio optimization in his South African futures market analysis. The early form of an Automated Trading System, composed of software based on algorithms, that have historically been used by financial managers and brokers. This type of software was used to automatically manage clients' portfolios. However, the first service to free market without any supervision was first launched in 2008 which was Betterment by Jon Stein. Since then, this system has been improving with the development in the IT industry. Around 2005, copy trading and mirror trading emerged as forms of automated algorithmic trading. These systems allowed traders to share their trading histories and strategies, which other traders could replicate in their accounts. One of the first companies to offer an auto-trading platform was Tradency in 2005 with its "Mirror Trader" software. This feature enabled traders to submit their strategies, allowing other users to replicate any trades produced by those strategies in their accounts. Subsequently, certain platforms allowed traders to connect their accounts directly in order to replicate trades automatically, without needing to code trading strategies. Since 2010, numerous online brokers have incorporated copy trading into their internet platforms, such as eToro, ZuluTrade, Ayondo, and Tradeo. Copy trading benefits from real-time trading decisions and order flow from credible investors, which lets less experienced traders mirror trades without performing the analysis themselves. Now, Automated Trading System is managing huge assets all around the globe. In 2014, more than 75 percent of the stock shares traded on United States exchanges (including the

New York Stock Exchange The New York Stock Exchange (NYSE, nicknamed "The Big Board") is an American stock exchange in the Financial District, Manhattan, Financial District of Lower Manhattan in New York City. It is the List of stock exchanges, largest stock excha ...

and

NASDAQ The Nasdaq Stock Market (; National Association of Securities Dealers Automated Quotations) is an American stock exchange based in New York City. It is the most active stock trading venue in the U.S. by volume, and ranked second on the list ...

) originated from automated trading system orders.

Market disruption and manipulation

Automated trading, or high-frequency trading, causes regulatory concerns as a contributor to market fragility. United States regulators have published releases discussing several types of risk controls that could be used to limit the extent of such disruptions, including financial and regulatory controls to prevent the entry of erroneous orders as a result of computer malfunction or human error, the breaching of various regulatory requirements, and exceeding a credit or capital limit. The use of high-frequency trading (HFT) strategies has grown substantially over the past several years and drives a significant portion of activity on U.S. markets. Although many HFT strategies are legitimate, some are not and may be used for manipulative trading. A strategy would be illegitimate or even illegal if it causes deliberate disruption in the market or tries to manipulate it. Such strategies include "momentum ignition strategies": spoofing and layering where a market participant places a non-bona fide order on one side of the market (typically, but not always, above the offer or below the bid) in an attempt to bait other market participants to react to the non-bona fide order and then trade with another order on the other side of the market. They are also referred to as predatory/abusive strategies. Given the scale of the potential impact that these practices may have, the surveillance of abusive algorithms remains a high priority for regulators. The

Financial Industry Regulatory Authority The Financial Industry Regulatory Authority (FINRA) is a private American corporation that acts as a self-regulatory organization (SRO) that regulates member brokerage firms and exchange markets. FINRA is the successor to the National Associati ...

(FINRA) has reminded firms using HFT strategies and other trading algorithms of their obligation to be vigilant when testing these strategies pre- and post-launch to ensure that the strategies do not result in abusive trading. FINRA also focuses on the entry of problematic HFT and algorithmic activity through sponsored participants who initiate their activity from outside of the United States. In this regard, FINRA reminds firms of their surveillance and control obligations under the SEC's Market Access Rule and Notice to Members 04-66, as well as potential issues related to treating such accounts as customer accounts, anti-money laundering, and margin levels as highlighted in Regulatory Notice 10-18 and the SEC's Office of Compliance Inspections and Examination's National Exam Risk Alert dated September 29, 2011. FINRA conducts surveillance to identify cross-market and cross-product manipulation of the price of underlying equity securities. Such manipulations are done typically through abusive trading algorithms or strategies that close out pre-existing option positions at favorable prices or establish new option positions at advantageous prices. In recent years, there have been a number of algorithmic trading malfunctions that caused substantial market disruptions. These raise concern about firms' ability to develop, implement, and effectively supervise their automated systems. FINRA has stated that it will assess whether firms' testing and controls related to algorithmic trading and other automated trading strategies are adequate in light of the U.S. Securities and Exchange Commission and firms' supervisory obligations. This assessment may take the form of examinations and targeted investigations. Firms will be required to address whether they conduct separate, independent, and robust pre-implementation testing of algorithms and trading systems. Also, whether the firm's legal, compliance, and operations staff are reviewing the design and development of the algorithms and trading systems for compliance with legal requirements will be investigated. FINRA will review whether a firm actively monitors and reviews algorithms and trading systems once they are placed into production systems and after they have been modified, including procedures and controls used to detect potential trading abuses such as wash sales, marking, layering, and momentum ignition strategies. Finally, firms will need to describe their approach to firm-wide disconnect or "kill" switches, as well as procedures for responding to catastrophic system malfunctions.

Notable examples

Examples of recent substantial market disruptions include the following: * On May 6, 2010, the

Dow Jones Industrial Average The Dow Jones Industrial Average (DJIA), Dow Jones, or simply the Dow (), is a stock market index of 30 prominent companies listed on stock exchanges in the United States. The DJIA is one of the oldest and most commonly followed equity indice ...

declined about 1,000 points (about 9 percent) and recovered those losses within minutes. It was the second-largest point swing (1,010.14 points) and the largest one-day point decline (998.5 points) on an intraday basis in the Average's history. This market disruption became known as the Flash Crash and resulted in U.S. regulators issuing new regulations to control market access achieved through automated trading. * On August 1, 2012, between 9:30 a.m. and 10:00 a.m. EDT, Knight Capital Group lost four times its 2011 net income. Knight's CEO Thomas Joyce stated, on the day after the market disruption, that the firm had "all hands on deck" to fix a bug in one of Knight's trading algorithms that submitted erroneous orders to exchanges for nearly 150 different stocks. Trading volumes soared in so many issues, that the

SPDR SPDR funds (pronounced "spider") are a family of exchange-traded funds (ETFs) traded in the United States, Europe, Mexico and Asia-Pacific and managed by State Street Global Advisors (SSGA). Informally, they are also known as Spyders or Spiders. ...

S&P 500 The Standard and Poor's 500, or simply the S&P 500, is a stock market index tracking the stock performance of 500 leading companies listed on stock exchanges in the United States. It is one of the most commonly followed equity indices and in ...

ETF (SYMBOL: SPY), which is generally the most heavily traded U.S. security, became the 52nd-most traded stock on that day, according to Eric Hunsader, CEO of market data service Nanex. Knight shares closed down 62 percent as a result of the trading error and Knight Capital nearly collapsed. Knight ultimately reached an agreement to merge with Getco, a Chicago-based high-speed trading firm.

References