It is simply a way to minimise the cost, market impact and risk in execution of an order.
It is widely used by investment banks, pension funds, mutual funds, and hedge funds because these institutional traders need to execute large orders in markets that cannot support all of the size at once.
Popular "algos" include Percentage of Volume, Pegged, VWAP, TWAP, Implementation Shortfall, Target Close.
Many fall into the category of high-frequency trading (HFT), which are characterized by high turnover and high order-to-trade ratios.
As a result, in February 2012, the Commodity Futures Trading Commission (CFTC) formed a special working group that included academics and industry experts to advise the CFTC on how best to define HFT.
This increased market liquidity led to institutional traders splitting up orders according to computer algorithms so they could execute orders at a better average price.
These average price benchmarks are measured and calculated by computers by applying the time-weighted average price or more usually by the volume-weighted average price.
to send small slices of the order (child orders) out to the market over time.
They were developed so that traders do not need to constantly watch a stock and repeatedly send those slices out manually.At about the same time portfolio insurance was designed to create a synthetic put option on a stock portfolio by dynamically trading stock index futures according to a computer model based on the Black–Scholes option pricing model.Both strategies, often simply lumped together as "program trading", were blamed by many people (for example by the Brady report) for exacerbating or even starting the 1987 stock market crash.The term is also used to mean automated trading system. Also known as black box trading, these encompass trading strategies that are heavily reliant on complex mathematical formulas and high-speed computer programs.Such systems run strategies including market making, inter-market spreading, arbitrage, or pure speculation such as trend following.Yet the impact of computer driven trading on stock market crashes is unclear and widely discussed in the academic community.