Algorithm trading, also known as automated trading or black box trading, is a systematic functioning of using computers which have been designed and programmed to follow a particular bunch of directives for making a trade with the sole purpose of making money at speeds which have been deemed impossible for a human investor or trader. The specified rules have been defined on the basis of timing, mathematical models or any quantity of stock. Setting aside the number of trading opportunities created by algorithm tracing for a trader, this type of trading liquidates the markets, making trading more calculated than emotional. For example, let’s assume a particular trader will follow these simple indicators for trading:
Purchases 50 shares when that stock’s 50-day moving average increases over the 200-day moving average and then sells the shares when its 50-day moving average reduced below the 200-day moving average
Using the above situation, it is far more convenient for a computer program to automatically evaluate stock prices along with the moving average factors and then place buy/sell orders when the specified instructions are met. This no longer requires a trader to keep a watchful eye over live stock prices and graphs; neither would he have to do everything himself. The algorithm trading process does this for him but more efficiently and with more scrutiny pertaining to the trading opportunity in question.
Benefits of Algorithm Trading
The following are the benefits providing by algorithm trading:
- Trades are placed at good prices.
- Trade orders are set accurately thereby increasing the chances of execution at any level.
- Trades are timed correctly so that price movements are avoided.
- Lower transaction costs.
- Multiple automated checks on different market situations.
- Lower risk of human and manual error.
Algorithm trading is utilized in many different trading/investing types which include:
- Traders and investors or firms which deal in pension funds and mutual funds or insurance firms who buy stocks in bulk quantities but don’t leverage the stock prices through high volume investments.
- Traders who are more systematic with their trades for example trend analyzers, pairs traders, hedge fund investors, etc, prefer to use algorithm trading and let everything be automatic.
Strategies Which Can be Infused with Algorithm Trading
Any trading strategy which is implemented with algorithm trading needs an evaluated opportunity which can be considered profitable when you talk about improved revenue and lower costs. Mentioned below are some of the strategies you can implement with algorithm trading:
Trend Following Strategies
Trend following is a common algo-trading strategy which takes into consideration all the trends in moving averages, price level moves, channel movements and other technical factors. Most traders use this strategy as it is the most convenient to implement through algorithm trading primarily because these strategies don’t involve price prediction, or any forecasts for that matter.
Purchasing dual listed shares at minimum price in a single trading market and at the same time selling it off at a higher price in other markets gives a price differential with a profit which is risk free. The same thing can be imitated when talking about stocks and future instruments because of the fact that price differentials exist in the market from time to time. Using an algorithm to determine different price differentials and then place buy/sell orders presents a good trading opportunity.
Time Weighted Average Price (TWAP)
This plan or strategy separates a bigger order and then releases them proportionally in the form of smaller chunks of the trade order into the market using consistently partitioned time slots between the beginning and ending time. The sole objective of this strategy is to accomplish the order near to the average price identified in between start and end times of the trade, which minimizes the impact on the market.
The mathematical and statistical modelling and evaluation of an algorithm’s functionality is imperative and should be done with absolute precision. Traders do feel overly relieved by the notion of automatic trading with the aid of computers because they can make money without have to do all the grunt work themselves, and this is how it should be. However, it is imperative that the system is tested through and through. And the traders using algorithm trading, who are also called analytical traders, must learn programming independently and to be smart and confident about sticking to their strategies.
Chris Turner is a versatile content writer with a passion for technology, finance, Investing and trading. He writes extensively on the subjects of Trading, Investing, Bitcoin, Forex trading, investing and general finance. He is writing and providing advice, education and encouragement to budding investors and traders, on Hedge Fund and alternative investments and other emerging financial trends. He is a contributor writer for HedgeThink.com and TradersDNA.com.