In Defense of Algorithmic Trading

Knight Capital’s unfortunate USD 440M loss associated with a software glitch in their trading systems is no reason to ban the practice of algorithmic trading. While we at First Degree do not engage in this kind of activity, we strongly defend the right of any market participant to approach the investment markets in any way they choose. Knight’s loss is ultimately someone else’s gain, so superior skills will be promoted and rewarded by efficient market forces.

Those of you who follow individual security markets are no doubt both dazed and confused by the speed with which orders are placed and cancelled by the algorithms employed by modern market makers. In the option markets, for instance, it is not uncommon for there to be bids and offers for 10,000 contracts on each side of the spread displayed on trading screens at any point in time. However, if a bona fide investor, say, attempts to buy 20 contracts of that security, the seller just disappears in nano-seconds and the investor may fill five or 10 contracts of his order. What appeared to be a deep market was actually a fake – the algorithms’ job is to quickly cancel orders in order to avoid being ‘shaken down’ by traders with superior information. Whoa-be-gone those genuine investors who place ‘market’ orders thinking there is 10,000 on the offer – the seller will ratchet up their offer price and fleece them for a few pennies more than they expected to pay. That is the job of the algorithm…

So it is with some sense of satisfaction that genuine investors have profited from Knight Capital’s cock up. Why they didn’t test their software on simulated data before implementation draws into question that company’s basic competency. If genuine investors can profit from a malfunction in an algorithm then bring them on.