This week's New Scientist has a good review article on algorithmic trading (Robert Matthews, Gordon Gekko makes way for trading software, 30 May 2007).
"Investors have realised that the processing speed and sheer volume of trades a computer can make can help them to outwit the sharpest of dealers. . . . Ten years ago, algo-trading was almost non-existent, but according to a recent report by [Brad] Bailey, now at the Boston-based consulting firm Aite Group, one-third of all trading decisions in US markets are now made by machines. He predicts that by 2010 more than half will be done this way. At Deutsche Bank in London, over 70 per cent of a category of foreign currency trades, called "spot trades", are now carried out without human intervention every day."
"Silicon is taking over from carbon on Wall Street," says Bailey.
"Dave Cliff, a computer scientist at Southampton University and founder of Syritta, a UK-based consultancy firm that develops algo-trading software [has turned to genetic algorithms to manage the large number of parameters that have to be tweaked.] His new system takes an initial set of guesses about the optimal selection of market parameters, tests how well each parameter describes prevailing market conditions, and then "breeds" a new selection from these to arrive at a more effective set. This evolutionary cycle is repeated until optimum values for the parameters are reached which the algo then uses to trade with."
"Human traders can make up for the lack of data with instinct and experience, and hooking human instinct up to computing power is now at the leading edge of algo trading. The result is software that helps the trader come up with ideas for bagging some alpha, and tests those ideas in simulations to see if they'll fly. With so many variables, it's easy to make mistakes, but the computer can spot them before unleashing the algo upon the market."