These algorithms increase the speed at which banks can quote market prices while simultaneously reducing the number of manual working hours it takes to quote prices. Some banks program algorithms to reduce their risk exposure. This allows the bank to maintain a pre-specified level of risk exposure for holding that currency.
The Future of Trading Starts Here
These processes have been made more efficient by algorithms, typically resulting in lower transaction costs. Yet, these are not the only factors that have been driving the growth in forex algorithmic trading. Algorithms have increasingly been used for speculative trading, as the combination of high frequency and the ability to quickly interpret data and execute orders has allowed traders to exploit arbitrage opportunities arising from small price deviations between currency pairs. Within the forex market, the primary methods of hedging trades are through spot contracts and currency options.
Spot contracts are the purchase or sale of a foreign currency with immediate delivery. The forex spot market has grown significantly from the early s due to the influx of algorithmic platforms.
In particular, the rapid proliferation of information, as reflected in market prices, allows arbitrage opportunities to arise. Triangular arbitrage , as it is known in the forex market, is the process of converting one currency back into itself through multiple different currencies. Algorithmic and high frequency traders can only identify these opportunities by way of automated programs. As a derivative , forex options operate in a similar fashion as an option on other types of securities. The foreign currency options give the purchaser the right to buy or sell the currency pair at a particular exchange rate at some point in the future.
Computer programs have automated binary options as an alternative way to hedge foreign currency trades. Binary options result in one of two outcomes: The trade settles either at zero or at a pre-determined strike price.
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There are some downsides of algorithmic trading that could threaten the stability and liquidity of the forex market. One such downside relates to imbalances in trading power of market participants. Some participants have the means to acquire sophisticated technology to obtain information and execute orders at a much quicker speed than others. This imbalance in algorithmic technology could lead to fragmentation within the market and liquidity shortages over time.
Furthermore, while there are fundamental differences between stock markets and the forex market, there is a belife that the same high frequency trading that exacerbated the stock market flash crash on May 6, , could similarly affect the forex market. Algorithms may not respond quickly enough if the market were to drastically change, as they are programmed for specific market scenarios. Markets may need to be monitored and algorithmic trading suspended during turbulence to avoid this scenario.
However, in such extreme circumstances, a simultaneous suspension of algorithmic trading by numerous market participants could result in high volatility and a drastic reduction in market liquidity. Algorithmic trading has been able to increase efficiency and reduce the costs of trading currencies, but it has also come with added risk.
For currencies to function properly, they must be somewhat stable stores of value and be highly liquid. Thus, it is important that the forex market remain liquid with low price volatility.
CAUGHT IN THE NET
Many investors are calling for greater regulation and transparency in the forex market in light of algorithmic trading-related issues that have arisen in recent years. On the positive end, the growing adoption of forex algorithmic trading systems can effectively increase transparency in the forex market. Algorithmic trading strategies — such as auto hedging, statistical analysis, algorithmic execution, direct market access and high frequency trading — can expose price inconsistencies, which create profitable opportunities for traders.
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