Algorithmic trading - naming confusion

Over the last few years algorithmic trading has become a hot topic. However there is still some confusion with other different types of trading, in particular "black box", quantitative and high frequency trading.

The algorithmic trading services which brokers provide are computerised systems responsible for executing specific orders to buy or sell a given asset. The decision to place these orders is actually a completely separate process - driven by the buy-side investors/traders. So in some ways the term algorithmic trading is an unfortunate choice, perhaps a more appropriate term is "algorithmic execution".

Direct Market Access (DMA) enables buy-side traders to issue electronic orders almost directly to the exchanges, by using a proxy for their broker's membership. Effectively DMA gives the buy-side much the same level of control over an order's execution as a sell-side trader has.

Systematic, black-box, high-frequency and automated trading are all terms which all sound like references to algorithmic trading. However these actually reflect quantitative investment strategies, often adopted by hedge funds or proprietary traders. These systems are responsible for actually instigating orders, although they may well actually use DMA or algorithmic trading systems to execute them. The following figure tries to illustrate this:

So together with manual trading, DMA and algorithmic trading form the three core execution methods for handling orders. They are also sometimes referred to as:

  • "High touch" = Manual trading
  • "Low touch" = Algorithmic trading
  • "Zero touch" = DMA

Black-box or quantitative trading follow systematic rules to initiate and close out positions, the investments may be for days or even months. High frequency trading is similar, but the timescales are shrunk, it aims to take advantage of intraday opportunities, so anything from hours down to fractions of a second.