Algorithm/Automated/ Quantitative trading is a type of trading process. In this, the trading rules are defined, and the instructions given are followed diligently. This kind of trading is done using computer programs. The buying and selling of various financial instruments (cryptocurrencies, stocks, etc.) are done by using computer programs. These programs have a defined set of instructions to carry out different trading functions. The program contains a trade indicator that triggers the program to carry out specific trades. Some of the examples of these triggers are: change in price, time, volume, etc.
Mechanics of Algo trading
In Algorithm trading, the actual trading functions (buying, selling, and tracking) are done by the computer-based on the instructions coded in the program. In this process, human intervention is limited until determining the set of rules for trading. The rules for carrying out various trading activities are definite. The programs carry out trading functions only when the conditions are met. The program carries out the trading functions effectively efficiently and in an automated manner.
Before running the program in the actual market, the investors carry out ‘back-test’. In this, the algorithm with a particular set of trading rules is tested on historical market data. In case of any issue, modifications are applied accordingly.
Tools for algorithmic trading
The algorithmic software used by the trader is the most critical tool of Algo trading. Hence, the selection of the right software is very crucial. Using software which lacks the required feature or is faulty, may result in huge losses.
Traders can either buy a ready-made algorithmic trading software or can even build their own software.
Some of the basic features of algorithmic trading software are:
- Availability of Market and company Data
- Connectivity to Various markets
- Latency
- Configurability and Customization
- Functionality to write custom programs
- Backtesting feature
- Platform-Independent Programming
- Easy plug-n-play integration
- Integration With Trading Interface
Pros and Cons of algorithmic trading
Trading in itself involves lots of risks. Every trading method has its positives and negatives. When it comes to trading, decisions based on emotions can be quite harmful. One of the most significant advantages of Algo trading is the lack of human involvement during actual trading. Trading done is at very high speed that too in a more effective manner. In addition to this, algorithm trading reduces operational costs. Algorithm trading results in the faster and automatic allocation of assets.
Let’s have a look at some of the major cons of using algorithmic trading. The primary issue faced by the traders is that the strategies used in Algo trading need to be monitored regularly. Another problem faced by individual traders is the lack of resources. The initial cost (server and software cost) associated with algorithmic trading can be quite high.
Pros:
- Emotionless Trading
- Less error
- More trading speed
- Ability to test strategies
- Risk Diversification
- Reduce operational cost
- Steady trading discipline
Cons:
- Needs constant monitoring
- The requirement of technological infrastructure
- Skills and knowledge for updating strategies
Algorithmic strategies:
Some of the most commonly used algorithm strategies are:
- Momentum Strategies: In this, the software action is based on a given moment or a given spike. The software detects the spike, and based on the instructions coded, executes the function of buying or selling order.
- Mean-Reversion algorithmic strategy: This algorithm is based on the assumption that the price of financial securities deviates back to its average.
- Market-making strategy: This trading strategy is more sophisticated. The algorithms used in this strategy are called liquidity providers. These strategies aim at capturing the spread between the purchasing price and selling price and carry out the trading process to reduce this spread.
- Arbitrage algorithms: These algorithms aim at finding the price difference between two different markets and carry out trading practices to make the best of this price difference.
- High-frequency trading: most of the big investment companies use high-frequency trading strategy. The trading order execution is based on market behavior. The trading is done on a large scale and at high speed.
In this trading strategy, numerous assets are traded parallelly in automatic mode to maintain balance in the portfolio’s value.
- Bollinger Band:
In this strategy, the algorithm computes three bands, namely, upper, middle, and lower band. The order is made when the middle band crosses either lower or upper band.
- CCI:
Commodity Channel Index is a trading strategy where the algorithms execute trading orders based on the CCI Index.
- Parabolic SAR:
The aim of this strategy is to forecast market trend changes and act as per the coded instructions.
- Slow Stochastic Oscillator:
This aims at earning profits by carrying out trading orders under specific market conditions.
Advantages of Algo Trading:
- Systematic and robust
The significant advantage of using Algo trading is that it allows the user to convert any trading strategy related idea to a set of instructions and rules whose effectiveness can also be checked using instruments like backtesting. Trading done under this method is more disciplined and structured. Also, the chances of human error are very less as there is hardly any human involvement in the actual trading stage.
- Speed and precision
Trading software can carry out trading transactions while scanning and executing several indicators at a time that, too, at a very high speed. Trading at the ‘right price’ is very crucial in trading. If you are looking for precision, Algo trading is an excellent option. Using algorithms for trading reduces the chances of errors that may occur if done manually.
- Flexibility and Diversification
As we all know, computers can continue giving their best performance without getting tired. The software can trade instruments that otherwise be difficult to trade if done manually. Also, users can design complex trading strategies that cannot be executed at the human level. This means Algo trading gives the user flexibility to develop their own trading strategy. Algo trading also allows the trader to diversify the risk.
