Algorithmic trading is the use of a computer program with a defined set of criterions to carry through trades. In theory, the use of algorithmic trading can generate trades and profit at higher frequencies than a human trader can.
The criterion for the system typically includes timing, price, or quantity. Algorithmic trading (also known as algo trading) offers high-profit opportunities and streamlines trades, as it removes any possible human variables. Here is a short example of how it works; For example, a trader has these set as criteria:
- The first specification is to buy 25 stocks when its 30-day moving average goes above the 100-day moving average. A moving average can be described as a series of averages of past data points to identify trends and smooth out the day to day price fluctuations.
- The second specification is to sell when the 30-day moving average goes below the 100-day moving average.
Algo trading offers a systematic approach to active trading in contrast to methods that may be based on instinct and trader intuition. Just as a human trader would, with these two specifications the computer system will automatically the moving average and the stock prices, as well as buy and sell orders when all the specifications are met. This removes the need for a trader to monitor the markets, live prices themselves or place the orders manually. The benefits of algo trading are numerous. All trades are executed at the best possible price, significant price changes are avoided, transnational costs are reduced, it runs automated checks on multiple markets, and finally, the orders are instant and exact. The algo trading system automatically does these actions by identifying strong trading opportunities based on the criteria.
- Algo trading can be used in mid to long term investments like mutual funds, insurance companies, and pension funds. This is because they can purchase large stocks in large quantities as they do not want to influence stock prices with large volume investments.
- Systematic traders, like trend followers, hedge funds and Paris trades; find efficiency in allowing the system to run automatically. Paris trades are a neutral market that matches short positions with long positions in highly correlated instruments such as exchange-traded funds, currencies, or stocks.
Algorithmic trading strategies
- Trend-following strategies
- Arbitrage Opportunities
- Mathematical Model Based Strategies
- Volume-weighted average price
- Percentage of volume (POV)
Implementing the designed algorithm on the computer is the last step of algorithmic trading. Another important thing that one must do before applying the algorithmic system is to backtest. Backtesting is trying out algorithms on past trading history to see if it would have increased your profits then. Always remember the more complex the algorithm the more backtesting is required to make sure everything is operational before putting it to action.
Algorithmic trading is not easy to set up or maintain if you have limited computer knowledge. Luckily, there are many award-winning traders that can help you start trading such as Kevin Davey, these traders can help with setting up a server and the upkeep as well as the nuances of a new system.