Algorithmic Trading is an automated process that uses computer programs and mathematical models for trades execution.
In financial markets, an algorithm is a defined set of instructions processed by a computer program to solve trading problems.
Algorithmic Trading a.k.a. Algo Trading became popular during the 1970s with an introduction if computerized trading systems.
In the book Flash Boys, author Michael Lewis talked about Algorithmic Trading. The book is about the lives if Wall Street traders who introduced electronic trading in the U.S.
Originally, Algorithmic Trading was executed by large financial institutions. Nowadays, individuals can develop an Algo to assess the market situation.
What is Algorithmic Trading?
Algorithmic Trading is based on price, time, and quantity. These factors help traders find trading opportunities. An Algo combines these mathematical data points with sometimes complex formulas to execute trades.
Once the trader finds the predetermined conditions, an algorithm will execute buy and sell orders on the trader’s behalf.
This is how Algorithmic Trading works:
To put the above diagram into theory, here’s an example of Algorithmic Trading.
Suppose a trader wants to buy 50 units of a particular currency pair when the 50-day EMA (exponential moving average) goes above the 100-day EMA. He/she would create a program that automatically monitors the conditions mentioned above and executes buy and sell orders when these conditions meet.
A trader doesn’t need to monitor the price constantly. Instead, an Algo would do his/her work. This is a major perk of Algorithmic Trading as it saves time and gets rid of any human emotions involved in trading.
Due to such qualities, financial institutions pay special heed to Algorithmic Trading.
It’s a familiar concept that automated trading and Algorithmic Trading are the same. Automated trading applies automation to manual trading an execute trades at a certain level. In contrast, Algorithmic Trading involves building a program that will scan the historical data and perform trade under pre-defined conditions.
Sometimes Algo traders use HFT (high-frequency trading). The HFT can perform thousands of trades in a second if the required technology is in place.
How to use Algorithmic Trading?
Algorithmic Trading is a computerized technique, so to put it into practice, all a trader needs is a code.
Before applying the code, it requires the back-testing of historical data. If it passes, a trader can implement the code should they wish to do so.
If a trader knows programming languages, the Algorithmic Trading development and testing process can be a lot easier.
Algorithmic Trading strategies
There are plenty of trading strategies that make use of Algorithmic Trading. Some of the most popular are; trend-following, mean reversion, and arbitrage strategies.
The idea of trend-following is to ride the trend until it lasts. The Algorithmic Trading strategies that follow the trend is applied through indicators like moving averages, price-level movements, or others.
A trader observes an uptrend. He wants to buy a currency pair when the 50-day moving average crosses above the 200-day. By designing a program that would implement these conditions, a trader would ride the trend until it starts reversing.
2. Mean reversion
Mean reversion a.k.a. range trading is a concept that describes that high and low prices of an asset are temporary, reverting to its mean value.
A trader would apply mean reversion with Algorithmic Trading when a particular asset’s price doesn’t move upwards and downwards for a longer duration. In this case, he/she would build an Algo that would look for short-term reversals and trade according to this information.
Arbitrage is a mechanism that circulates buying an asset in one market and selling it in another market. The profits or losses are based on the difference between the rates of an asset between markets.
Using arbitrage in Algorithmic Trading, a trader would program an Algo, looking for the difference between the price of an asset in two markets. The trade would then be executed.
Algorithmic Trading conclusion
Algorithmic Trading compromises of numerical data and a code to carry out trading. Mathematics and coding is prerequisite for Algorithmic Trading. The more complex the algorithm would be, the more difficult it can be to develop.
It is very important to note that Algorithmic Trading is often based on historical data and there is absolutely no guarantee on how a trading strategy will perform in the future based on past results.