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Algorithmic Trading: What The New Age Of Cyber-Investment Means For Your Money

Reports coming out of New York suggesting that market volatility, or the degree to which stocks change in value, may be permanently higher. This increase in price volatility is due to the increasingly widespread use of algorithmic trading: a system in which computers are fed huge volumes of data and then make transactions as fast as the speed of their processors will allow them for the purpose of maximizing the proceeds of sales of stocks. While this technology has made investment companies lots of money, the common set of algorithms does mean that minor changes in market data tend to produce larger swings than they used to historically. This is because the speed of transactions has increased, and the time spent thinking about decisions has decreased. Small changes in market conditions, then, tend to produce much larger results than normal.

With the uncertainty in financial markets that appears to be the new normal, many investors are reviewing their options and seeing if they've got their money in the right places. Let's take a look at a few common questions about financial instruments in light of this new technology-based finance sector.

What instruments do algorithmic traders use?

Mostly, these trading protocols focus on shares in individual companies because these instruments have the greatest volatility. They may also trade other instruments whose prices fluctuate, like exchange-traded funds (ETF's) as well as complex financial instruments, like commodities, futures, and options contracts. If you recall the stories of day trading in the mid-to-late 1990s, investors would make money by executing high-volume trades when the price difference between buy and sell was only a few pennies. The same is true for algorithmic traders. So, in order for an instrument to be profitable to an algorithmic trader, the price has to change a great deal, and there can't be barriers to transactions.

Does this mean I should stay away from machine-traded instruments?

Not necessarily, though it does mean you have to be more cautious. Trying to make money through a growth in stock price is already a risky proposition, and the presence of computers executing thousands of transactions a minute makes it even more so. If a stock that you've bought starts to slip in value, the algorithmic traders will detect and react to those changes far faster than you can.

There are still relatively safe individual share transactions you can find, provided you're willing to be patient and not expecting to make a fortune overnight. Pursuing a diversified investment portfolio that focuses on stable, growth-oriented companies is still a safe strategy. The rise of the machines has really only made for more hazardous trading in small companies that are hoping to get in on the ground floor.

It's also important to note that algorithmic trading of mutual funds, like most retirement fund products, is not profitable. A fund manager has to approve investment in a fund, which delays the trade. This isn't a significant barrier to individuals looking to invest money for the future, but it is quite an impediment to machines trying to engage in micro-transactions.

Can I get involved in algorithmic trading?

There are a few things you need to compete in this market, most of which are out of reach to individual investors. You need a really fast Internet connection, ideally in New York. The difference in time it takes for information to go from New York to Chicago is measured in milliseconds. It's not enough to matter if you're browsing the web, but those milliseconds are tremendously important in minor price fluctuation. You also need a top-of-the-line server computer. These monstrous behemoths have multiple processors and are capable of performing billions of calculations per second. Their prices usually start around $50,000. You also need a lot of capital. In order to make these kinds of transactions, which usually work in margins of a few cents, profitable, you need to work in tremendous volume. Buying a million individual shares at $1 each and selling them back at $1.01 makes an algorithmic trader $10,000, but they needed to already have a million dollars to make money on that small a price change.

These barriers explain why most of the organizations involved in algorithmic trading tend to be major investment banks and other large, national credit entities. These organizations have the resources and staff to put their financial decisions in the hands of a computer. For individual investors, this technology is largely out of reach.

Should I reconsider safer financial instruments to avoid this volatility?

Possibly. Because of increased overall market volatility, many investors are choosing to invest more heavily in longer-term, more stable financial products, most notably, corporate and government bonds. These instruments tend to be longer-term and pay a fixed yield. They also tend to be far more stable in pricing. The slower changes in their value make them unattractive for algorithmic traders.

By far, one of the safest places your money can be, though, is in your credit union's high-yield savings accounts. Whether in a certificate account or a money market, your savings will earn a stable rate of interest, guaranteed by a stable community institution as well as the Federal Deposit Insurance Corporation (FDIC). As market volatility continues to make individual securities a less attractive investment for long-term savings, your money in a certificate will continue to earn the same rate. You can rest easy knowing your financial future is in the hands of a skillful banker instead of a giant computer in a windowless room.