“Algorithm” is one of those words banded about very liberally these days.

Personally, it still makes me think (with a cold chill) of math’s lessons with Mr. Henson, and the daunting “super computer” sitting on my classroom desk that was my new scientific calculator!

But, of course, algorithms are all around us, in the formulae that explain the world, and how we humans interact with it.

And trading algorithms are serious business.

The power that algorithms have in the markets has grown and grown over the past two decades, yet the average investor is largely unaware of them.

If we understand a little more about how to use them – they can have a powerful effect on our trading.

But it’s important to understand, that the kind of algorithms that are run by trading institutions in high-frequency trading, are very different from the kind of algorithms that can help us humble traders, who don’t have millions of pounds of liquidity at our disposal …

One trading strategy I’ve recently been sent details of uses algorithms developed in aerospace technology, and claims to have accurately predicted every major reversal on the Dow for the past ten years – and that it can do the same for the forex markets.

If you think that sounds far-fetched, then you’ve some catching up to do …

The growth of trading algorithms in the markets

Algorithmic trading uses coded programs for entering trading orders with the algorithm deciding on various aspects of the order, such as the timing, price or quantity. This kind of computerized trading first appeared on Wall St in the 1980s. Since then, computers have grown more powerful and the algorithms that guide their trading more sophisticated.

While the companies using these programs to carry out high-frequency trades make up just 2% of financial institutions trading – they are responsible for 60–70% of market volume.

These algorithms can do in a microsecond what it would take humans hours to do manually. They can analyse rafts of information … balance probabilities … manage risks … and probably make a mean cup of coffee too …

The big institutions create and use the largest and most complex algorithms – stuff that, I’ll be frank, is way over my head …

… Like “Guerilla” (also from Credit Suisse) that can slice big orders into smaller unobtrusive sizes to minimize impact on the market …

… Or like “Sniper” developed by Credit Suisse to detect “Dark Pools of Liquidity” (no, these aren’t a place in Mordor – they’re thinly traded anonymous sources).

… Or like “Sniffer”, which hunts down other algorithms in the market, and attempts to mimic their strategies (how clever is that?) …

Suddenly claims that an aerospace algorithm can predict the movements of the forex markets doesn’t sound so wild.

How algorithms can help home traders

While algorithms are undoubtedly very clever, and all the big players are employing them. As I said earlier, when it comes to individual traders, who don’t have £millions of liquidity – the type of algorithms that can help us are very different.

I don’t believe that algorithms can replace humans in decision making. Sure, they’re fast, and they can deal with more information in a minute than I could work through in a lifetime, but I will always want to have my finger on the “buy” or “sell” button.

There’s no way that a computer program can understand external factors in the way that a human can. It’s a lesson I’ve learned the hard way – by trusting my money to some forex robot, who’s kindly emptied my trading account for me overnight.

Left entirely to their own devises, algorithmic trading systems can cause strange anomalies, like the “flash crash” in May 2010, when the Dow Jones fell by almost 1,000 points in the space of five minutes. This wasn’t caused by fear in the market – it was caused by high-frequency trading – where trading robots, or “black boxes”, automatically create orders, and the markets spiraled out of control.

Now, the aerospace algorithm I’ve been talking about isn’t the sort of strategy used by high-frequency traders. Instead, it’s the kind of strategy that can help individuals. It can give trading signals, but it doesn’t do the trading independently.

While I’m very open to using the power of an algorithm to guide my trading – I’ll always steer clear of black boxes and forex robots.

I’ll let you know how I get on.