Published on July 9th, 2021 | by Sumit Bhowal0
How Algorithmic Trading Works: All You Need to Know
A stock market is a voracious place if you don’t understand it. However, several tools help investors make intelligent decisions. Algorithm trading is one tool that can trade stocks with high speed and accuracy. This is a new way of stock trading using artificial intelligence and machine learning. It is a mathematical approach to trading that has transformed the competitive industry of financial markets. This article helps you understand the technical aspects of algorithmic trading and how you can use it.
What is algorithmic trading?
Image source: https://unsplash.com/photos/OqtafYT5kTw
Algorithmic trading involves implementing trading strategies using computer codes and programming. It entails turning a trading idea into an algorithmic trading strategy. In the simplest terms, algo trading is where you trade in forex using a computer program. Instead of manually buying and selling orders, you implement a computer algorithm to monitor the market and execute the trade.
Automated trading uses strategic algorithms to make a trade, create orders and manage order submission. Automated Options Trading uses strategic algorithms to make a trade, create orders and manage order submission. The algorithm will read incoming prices from different exchanges, convert them through exchange rates, and determine if the arbitrage is large enough to make money.
You instruct a computer program on the price, timing, and other mathematical models. It will monitor the stock prices and place an order to buy or sell orders based on your instructions. The algorithm eliminates the need to track live prices as the trading system automatically identifies the trading opportunity.
You need some technical abilities to set up an algorithm to do your trading. For example, you need computer programming skills and knowledge of trading strategy. However, you can use the python algo trading library to develop trading algorithms that might be difficult with computer programming.
How does algorithmic trading work?
Image source: https://unsplash.com/photos/cvBBO4PzWPg
Algo trading uses computer codes to enter and exit trades according to set parameters such as price movement and volatility. During the process, you code an algorithm to perform a specific trading activity based on market conditions. Once the market conditions align with any predetermined criteria, the trading algorithms execute a buy or sell order on your behalf.
Algorithmic trading starts with creating a robust trading strategy. There are three types of trading strategies you can use when building your algorithm. They include price action, technical analysis, and a combination strategy. Price action strategy entails looking at the previous high and low points on a chart. The algorithm triggers a trading order if they achieve similar levels. Assess whether you want to go long or short and consider measures to manage risks before using this strategy.
The technical analysis strategy focuses on monitoring indicators such as relative strength index to create an algorithm. For example, you can close a position when volatility levels spike. This strategy is less focused on price and more interested in using indexes to trigger a trade order. A combination strategy uses both price and technical analysis to trigger trade orders. You must analyze the price actions in a market and understand different technical indicators. Configure the combination strategy according to the market, time frame, and size of the trade.
Types of algorithmic trading systems
Image source: https://unsplash.com/photos/9SoCnyQmkzI
There are several types of algo trading systems, each with a different purpose and use. Robo advisory is an algorithmic trading platform where technical analysts create a strategy and monitor its performance.
Statistical algo trading entails using historical market data to trade. This is where you compare historical market data to the current data before investing. You can use this trading for price action and trend following, where you compare previous market trends with the current ones and identify profitable trading opportunities.
It differs from algorithmic trade execution that focuses on making trade quickly. It’s popular with scalpers interested in aggressive and high-frequency activities. You use it to trade at a fast pace throughout the day and earn huge profits. Algorithmic hedging is the most balanced trading system that allows traders to invest after getting a balanced exposure to the market. You use it to find opportunities and exploit price differences in the market.
Benefits of algorithmic trading
Image source: https://unsplash.com/photos/5Ntkpxqt54Y
There are many benefits of algo trading for any trader. Trade order placement is instant and accurate, with trades timed correctly to avoid significant price changes. This reduces the risk of manual errors when placing orders as you don’t trade with emotions. Also, the algorithm executes a trade at the best possible prices while reducing the possibility of mistakes made because of emotional and psychological factors.
Another advantage of algorithmic trading is the reduction in transaction costs by simultaneously checking on multiple market conditions. It capitalizes on special events to place many orders at high speeds across various markets. The technology renders the market more liquid with systematic trading and can open up opportunities to earn vast amounts of money in a single day.
Risks of auto trading
If you can place an algo-generated trade, someone somewhere can also trade, leading to price fluctuations. As a result, you can lose money if the algorithm is slow in processing data. There are other risks such as system errors and network outages that could affect the algorithm efficiency. Imperfect algorithms are prevalent among traders that can be a risk. The practice of algorithmic trading is tough to execute without knowledge of computer programming.
The Bottom Line
Algorithmic trading helps investors make more intelligent trading decisions using analytical and technical strategies. It provides a systematic approach to active trading. Modern technology has facilitated this type of trading through machine learning and artificial intelligence. Therefore, algo trading is already here and growing exponentially. The future looks verdant as people look for opportunities to amass more profits in the stock market. It helps anyone who doesn’t watch market trades or multiple stocks make intelligent investment decisions.