An algorithm is a defined set of instructions that are designed to conduct an activity or process. Although it has its origin in Arabian mathematics, an algorithm is now commonly associated with computer programming. Algorithmic trading is done using a computer program that runs on algorithmic instructions to carry out a trade. It is also known as automated trading, black-box trading, or algo-trading.
Algo trading is gaining increased attention due to its potential of garnering profit at a speed and frequency that is not possible for a human. The instructions embedded in algo trade take factors like timing, price, quantity etc. which provide more profit opportunities to the trader and makes the market more liquid. Being automated, it eliminates the impact of human emotions on trading activities.
Algorithmic trading is known to have many benefits. It includes,
Besides, a large portion of algorithmic trading is done through high-frequency trading (HFT). HFT aims to achieve large order quantities at high speeds and across multiple markets. While doing so, multiple decision parameters are kept in consideration as per the pre-programmed instructions.
Algorithmic trading can be explained with the below example.
Suppose you want to buy 100 shares of a company when its 50-day moving average exceeds its 200-day moving average. And then you set a sale order when the 50-day moving average dips below the 200-day moving average. The moving average is the average of the daily prices after eliminating day-to-day price fluctuations.
Based on these two simple instructions, the algorithm will monitor the stock price. As and when the set instructions are met, it will place the buy and sell orders. As a trader, you no longer need to monitor live prices and place orders. The algorithmic trading system does this automatically by correctly identifying the trading opportunity.
Mid to long-term investors and buy-side firms like pension funds, mutual funds, and insurance companies. They purchase stocks in large quantities but avoid large volume transactions to negate sharp influence on stock prices.
Short-term traders and sell-side participants like market makers, speculators, and arbitrageurs. Algorithmic trading helps sellers to create liquidity in the market.
Systematic traders like trend followers, pairs traders, hedge funds, etc. can use algo trading to program their trading rules and make it run automatically as per their customized specifications.
There are also several drawbacks or disadvantages of algorithmic trading to consider:
Algorithmic trading is legal and there are no rules or laws that limit its use. While some market watchers may accuse algo trading of creating an unfair trading environment, there's nothing illegal about it. However, claims of profit made in the past or expected future profits through algo trading made by entities not regulated by SEBI are illegal.
Algorithmic trading is heavily reliant on quantitative analysis or quantitative modeling. The first step would be to understand the market and the instrument you intend to trade. Your algorithm will be based on your understanding, goals and return expectations. The algo strategy must be coded by experts, followed by its backtesting. There is various third-party backtesting software that can be used for this purpose. You have to use the algorithm on a brokerage platform that supports it. Your trading strategy is now good to go live, but regular monitoring and updating of the strategy are important.
You can make money by adopting algorithmic trading into your trading practices. It will bring in a more systematic and defined approach to your trading activities. As a result, you will be identifying and executing trades more efficiently compared to manually traded orders. It will also help you in executing trades at a more pinpointed price and avoid human latency in the process.
However, it is important to note that algorithmic trading is not a magic drug for making money. It is subject to the same risks and uncertainties that are inherently present in any other form of trading. Losses may be incurred even with an algorithmic trading system. Besides, the boons of algo trading come at a cost. As discussed, the development and implementation of an algorithmic trading system are capital-intensive. It is not a DIY solution that ordinary traders can use. They are likely to be charged an ongoing fee for its use. Not to forget, careful research and understanding of the potential risks and rewards are important in algo trading, just like any other form of investing.
To achieve the efficiency required to process high volumes of data, C++ is the programming language of choice for algorithmic trading strategy developers. However, C and C++ are both complex languages, so finance professionals can opt for languages like Python while making an entry into programming.
With algorithmic trading, you get integration of computer software into financial market transactions where trades are based on programmed code. Investors and traders can predefine when and at what level they want trades to open or close.
Algorithms and technology make the performance of high-frequency and high-volume trading possible. Algorithmic trading is increasingly prevalent in financial markets today for the customizable strategies that traders can choose or design. You can use it to be a fast, efficient and successful trader.