Algorithmic Trading is Not High Frequency Trading

Though I do get a chuckle out of the extremely bombastic stories ("MAN OBSOLETE? COMPUTERS TAKING OVER!!!"), it's nice to see the record set straight. Sadly this will get 1/10000th of the page views of the garbage articles it dissects.

Also, what IS algo trading?

Is a margin call algo trading? Is a stop loss algo trading? What about technical analysis?

(Flash) crashes should be expected anytime you over leverage your entire economy.

See: George Soros and the pound.

Imagine everyone you know has widgets, and you realize that most people like to keep their widgets in a warehouse. You setup a warehouse that stores widgets and people pay you to store their widgets. Everyone loves it, no more widgets around the house cluttering things up.

Now since the widgets are identical and interchangeable you stop tracking whose widgets belong to who and throw them all into a big pile, and when someone asks for their 20 widgets you give them a random 20 widgets.

Now you realize that keeping all these widgets around is a massive waste of time and money since only about 1% of widgets are actually in use before being returned to the warehouse. So you tell your customers, "hey, I'm not going to bother actually keeping all the widgets, and I'm going to stop charging you to store your widget and instead I'll pay you to keep your widgets, if you store your widgets for a year I'll give you an coupon you can bring back to me at the end of the year and I'll give you all your widgets back plus 10% more".

This system works great and everyone is happy, after a few decades the coupons for the widgets outnumber the widgets by a factor of 10,000.

Now some asshole with a basic grasp of mathematics invents a computer program to manage widget coupons and it realizes that if it buys 1/10000th of the widget coupons and redeems them for widgets that no one else can actually redeem any other coupons. So your computer takes delivery of all the widgets in the world and then redeems one more widget coupon and everyone loses faith because the coupons for widgets no longer get you widgets and suddenly widget coupons are only worth 1/10000th of a widget. Suddenly everyone is mad at the guy with the computer and basic grasp of mathematics because their widget coupons only buy 1/10000th of a widget, and he's making bank selling everyone their widgets back.

Is the cause of the devaluation of widget coupons the fault of the algorithm, or the fault of the system that allowed more coupons than there are widgets?

The big problem when you place a huge buy or sell order is that it shifts the price in a direction you don't want it to go. For a large sell order, the price goes down, as the market becomes skittish about the security. For a large buy order, the price goes up, as the market becomes bullish and arbitrageurs quickly buy up securities to resell to you. So, many traders use algorithms to hide their trades. The purpose of these algorithms is to avoid volatility, so they shouldn't be dangerous to the market, as long as they're designed correctly.

(Although, to be fair, algorithms may automatically stop trading when the market becomes too volatile, which contributes to flash crashes by reducing liquidity.)