For many investors and traders in the capital markets, both retail and institutional, as well as for wholesale commodity and energy market participants, algorithms play a significant role in the deal-making process. While in the financial markets investor orders are generally routed and executed through broker algorithms of various types, the ability to use routing and execution algorithms directly is also becoming more accessible to investors, as are the data feeds and processing tools that are essential to the use of algorithms. Some investors, both retail and institutional, also use algorithms to actively make investment and trading decisions through the rapid analysis of potentially voluminous amounts of market data. In other cases, investors track an outside reference, such as an index, and investment and trading decisions may be informed by algorithmically-determined decisions about composition implicit in a benchmark index or other standard or set of rules.
In the commodity and energy markets, algos are also applied in more and more situations. This serves both investors (as explained above) and physical parties that play a role in the supply chain.
Algorithms address many of the challenges and choices market participants have in the field of trading, namely as follows:
- What instrument(s) should be transacted?
- What price should be bid or offered (maximum buying price, minimum selling price)?
- What order size is optimal?
- What should be the response to a request for a quotation (RFQ)?
- What risk will be taken on by facilitating a trade (direct electronic/market access, sponsored access)?
- How does that risk change with the volume of the deal?
- Is the risk of a trade appropriate to a firm’s capital?
- What is the relationship between the price of different though related products?
- To which market should an order be submitted?
- Is it more effective to provide liquidity or demand liquidity (market making, market taking)?
- Should an order be displayed or non-displayed?
- To (or via) which broker should an order be routed?
- When should an order be submitted to a trading venue?
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