Algorithmic Trading
A strategy that employs a computer algorithm to generate buy and sell orders and submit them to the market via a brokerage platform
What Is Algorithmic Trading?
Algorithmic trading is a strategy that employs a computer algorithm to generate buy and sell orders and submit them to the market via a brokerage platform. But what exactly is an algorithm? An algorithm is a set of instructions for completing a task or solving a problem.
An example of an algorithm would be following directions from Google Maps, which consists of specific instructions or directions to reach a particular endpoint. In today's day and age, algorithms are present in every industry and play a crucial role.
Algorithms (Algos) are used to automate trading to make a profit at a frequency that a human trader could not achieve.
One of the most important aspects of algorithmic trading is removing the emotional component from trade execution. Institutional investors use algorithms like hedge funds, investment banks, etc., due to the sheer number of transactions they go through daily.
Key Takeaways
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Algorithmic trading utilizes computer algorithms for automated buying and selling in financial markets.
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Algorithmic trading often employs principles of machine learning, a subset of data science. Machine learning allows computers to learn and improve without explicit programming and is used to enhance trading systems.
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Algorithms scan the market for specific trade setups based on predefined criteria. Once identified, these algorithms execute and manage trades automatically, removing the emotional component from trading.
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Algorithmic trading balances automation benefits with challenges related to technology, control, monitoring, and market behavior.
Understanding Algorithmic Trading
Algorithmic Trading works on the principles of Machine Learning. Machine learning is a subfield of data science that allows computers to learn and improve without programming.
Machine learning focuses on creating systems that can automatically get large amounts of data and alter their settings to improve user experiences. Computer systems work in the background and deliver results based on how they have been trained.
Algorithmic trading may examine massive amounts of data at the same time and execute thousands of deals every day.
Since stock, bond, and commodity prices are available in various formats, the process of an algorithm analyzing large amounts of financial data becomes simple. The program user sets the parameters and gets the desired output when securities meet the traders' criteria.
How Does Algorithmic Trading Works?
In essence, computer algorithms scan the markets for trade setups that satisfy their criteria. Once they find them, they execute and manage the trades according to the instructions specified in the code. This information is usually the appropriate position size and trade exit conditions.
The entire process is automated, from finding trade setups to executing and tracking the deal. However, before a trading algorithm can be used on a live account, it should go through testing on historical price activity over a long period. This would eliminate curve fitting.
The algo system must go through evaluation using the walk-forward approach, often known as forwarding testing. Forward testing simulates the system's performance in a real-time market. If a strategy performs well in advance testing, it will most likely perform well in a real account if market circumstances do not change significantly.
High-frequency trading (HFT) is the most common type of algo-trading today, which tries to profit by making a large number of orders at high speeds across numerous markets and decision factors using pre-programmed instructions.
Algorithmic Trading Strategies
A variety of strategies are used in algorithmic trading and investment.
Some of these tactics aim for long-term gains, while others are more concerned with short-term gains.
Momentum investment is one of the most fundamentally used algorithmic trading strategies. This style of investing looks for a substantial move in one way on strong volume in the market. This trading strategy can be either easy or extremely complex.
A simple momentum investing strategy may put money into the five best-performing stocks in an index based on their 12-month performance. A more challenging strategy would involve combining relative and absolute motion throughout time.
This approach also allows investors to rebalance momentum systems on a weekly, monthly, quarterly, or even yearly basis.
The mean reversion technique takes advantage of the fact that many asset prices tend to return to the mean following periods of being either oversold or overbought. This technique assumes that the stock's price will eventually revert to its long-term average price.
They will buy assets when they trade at the low end of a trading range. Conversely, investors prefer to sell assets as they approach the trading range's center or a moving average.
3. Factor-Based Investing
Factor-based investing is a method in which investors select assets based on characteristics linked to greater returns in the past. This system has two basic categories of variables that have driven stock, bond, and other factor returns.
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Many financial investors will use a static weighting method or a dynamic allocation to combine these criteria.
4. ETF Rotation Strategies
Some investors use ETF rotation methods to maximize return for a given amount of risk. This is something that investors may accomplish in a variety of ways. To optimize return, the strategies rotate into ETFs with significant momentum.
These techniques can also transfer funds into uncorrelated ETFs when market circumstances are turbulent to reduce risk. Investors use these tactics to take full advantage of trends identified by quantitative research.
5. Smart Beta
A smart beta is an investment approach that aims to bridge the gap between active and passive investing.
The purpose of a smart beta approach is to reduce risk or promote diversity at a lesser cost than standard active management would. This technique focuses on collecting investment characteristics of market inefficiencies in an open, rule-based manner.
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Investors for portfolio risk management and diversification prefer using smart-beta systems. Smart beta is a technique that applies to a variety of asset classes.
6. Trend Following
Trend following is one of the oldest tactics employed by investors when it comes to algorithmic trading. Algorithms scan the market for indicators to execute trades in this technique.
Technical analysis, market patterns, and indicators are commonly used to make judgments in these transactions.
This approach aims to buy assets when they break through resistance levels and sell short when they fall below important support levels. Investors like this method because of its convenience when compared to other algorithmic trading systems.
7. Sentiment Analysis
This strategy is determined by crowd reactions, as investors stay up-to-date on recent and relevant news. This method is used by many advisers and investors to profit from short-term price fluctuations.
8. Statistical arbitrage strategy
Statistical arbitrage systems are a set of statistically driven trading methods. This technique aims to profit from relative price changes of financial instruments by examining prices and trends. Investors use this approach to produce higher-than-average returns.
9. Seasonality strategies
Depending on the time of year, investors may opt to develop strategies. Many investors know that stock markets perform better at the end of the year and throughout the summer months. They may also be aware that September is traditionally a low-return month.
Advantages of Algorithmic Trading
The advantages are:
1. Increased Speed
One of the essential benefits of algo-trading is the increased speed it provides. The algorithms can examine a wide range of characteristics and technical indicators in a fraction of a second and execute trades.
The enhanced speed becomes critical since traders can record price swings as soon as they occur.
2. More Accuracy
Minimization of human participation is another crucial advantage of algo-trading. This results in reduced chances of making an error.
The algorithms are double-checked and triple-checked and are unaffected by human mistakes. It is conceivable for a trader to make a mistake and improperly assess technical indications. In ideal conditions, computer systems do not make such errors.
3. Minimization of human emotions
The most significant advantage of algorithmic trading is the reduction of human emotions. The tactics are pre-determined, and the traders are not allowed to be led by their feelings.
The deal is automatically completed once the pre-required objectives are met. The trader does not have the option of contemplating or criticizing the trade.
It prevents both under-trading and over-trading. There are no psychological aspects to the transaction, and there is no space for departure from the basic tactics.
4. Increased market volume
It allows massive numbers of shares to be purchased and sold in a matter of seconds. As a result, the market's total volume and liquidity grow, while the trading process becomes more simplified and organized.
5. Improved Order Entry Speed
Algorithmic trading automatically executes transactions. The system reacts to market changes and produces orders as soon as the trading requirements are satisfied.
The pace with which you enter and exit the market is crucial to the trading process. Even a few seconds of delay might result in losses. Thus, a better speed of entry and exit helps the traders in capturing the price movements at the exact point.
6. Diversification
Algorithms and computers are used in algorithm trading. As a result, the procedure of executing many trades and strategies at the same time becomes quite simple.
Trading possibilities can be scanned across a variety of marketplaces, assets, and instruments. In the absence of automation and algorithms, this leads to diversity, which is problematic.
7. Maintaining discipline and consistency.
It is believed that the most difficult component of trading is planning the trade and trading according to the strategy. The market volatility makes it difficult for traders to stick to their plans, even when they have developed techniques.
Algo-trading addresses market volatility by assisting traders in being consistent and disciplined. The strategy's logic is preserved and not derailed by the effects of emotions such as fear and greed.
8. Automation of the asset selection process
With the aid of Algo trading, asset selection, order execution, and entry and exit process become more systematic. It devolves into a process of following instructions step by step. Trading becomes much more simplified as a result of this.
Disadvantages of Algorithmic Trading
The disadvantages are:
1. Dependence on Technology
The major disadvantage of algo-trading is its extreme reliance on technology. In many circumstances, trading orders are stored on the computer rather than on the server. This indicates that the order will not be transmitted for execution if the internet connection is lost.
This betrays the entire algo-trading concept. Traders who miss out on possibilities in this situation risk losing money.
2. Loss of Human Control
Humans are deprived of the ability to make independent decisions. Even if a trader recognizes that the strategy would not work given the circumstances before the order is executed.
He has no control over abandoning the program and terminating the deal. Even if the trader does not want the program to go in a particular direction, there is no way to halt it and limit the losses.
3. Need for Constant Monitoring
The ideal vision of algo-trading is that the algorithms are pre-programmed, and the trader may be away from his computer for extended periods.
The reality is not the same. The trader must continue tracking the system for mechanical faults such as connection, power outages, etc.
Although the methods are built into the servers, they must be checked to ensure that they are carried out correctly. The algorithms must also be checked to verify that no orders are missed, duplicated, or incorrectly placed.
4. Need to Know the Programming Process
Algorithm trading necessitates the development of algorithms by traders. Not every investor has a technical background. As a result, they may need to recruit someone or learn new methods. For the average person, algo-trading is difficult because of the requirement of technical knowledge.
5. Over-Optimization Risk
Likely, the methods devised on paper will not prove to be profitable and effective when used in actual trading. This is also known as over-optimization, and it occurs when a trading strategy becomes unreliable in real-time markets.
Although tactics are based on previous data, there's a good chance they could fail as soon as they go live if the correct approaches are not used.
6. Resource Requirements
While algorithm trading reduces transaction costs, it also adds significant expense. The traders will require high-end resources, access to the server, and the ability to design algorithms.
Another high cost is the cost of data feeds, which aid in the development of intraday strategies.
7. Inability to Understand Irrational Markets
The simple fact is that algorithms are automated instructions. They are incapable of comprehending events and circumstances in the same way that human minds can. A trader can recognize the market's illogical behavior and react appropriately.
The algorithms can only comprehend flawless circumstances. They lose control in crazy markets and become erroneous in out-of-the-ordinary circumstances.
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