It is often that investors raise queries on what is algo trading, how a trading is done with this mechanism, can a retail investor do algo trading, what are the associated risks and so on. This article is dedicated to all those people who want to learn about algo trading and/ or want to start algo trading. Let us first begin with learning the meaning of algo trading.
Meaning of Algo trading
Algo trading is also known as Algorithmic trading, automated trading and blackbox trading. The clearly defined set of instructions which are aimed so as to carry out a task or process is known as algorithm. Algo trading uses the concept of algorithm. In algo trading, computer programmes are used. These programmes are basically a set of instructions that can automatically place a trade. The major use of these programmes is that one can not only quickly trade but one can also generate a profit at a speed which is practically impossible for a human being to achieve if he works manually. The programme is set taking into consideration the various rules like timing, price, quantity and the mathematical model. Since the trading is done using computer programme, another benefit of this type of trading is that it rules out any possibility of human emotions coming in between the trade decision. In addition, algo trading results in more liquidity and systematization in the market.
For example, a trader sets the computer programme with the condition to purchase 100 shares of a stock if its 50 days moving average exceeds the 200 day moving average and to sell 100 shares of a stock if its 50 days moving average falls below the 200 day moving average. Now, he is free from the tension of looking at the price changes.
Snapshot of benefits of algo trading
- Trading is executed at a very fast speed.
- Trading is executed at best possible prices
- Since the trading is fast, the impact of price changes are minimal
- Transaction costs are reduced
- While placing the orders, minimal manual errors are encountered
- Simultaneously multiple checks can be conducted on multiple market conditions
- Elimination of human emotions and psychological factors on trading
Categories of investors who use algo trading
- Mid to long term investors or mutual funds, pension funds, insurance companies who usually purchase stocks in bulk.
- Short term traders, speculators who are more interested in profit booking. It is because of these traders that liquidity is infused in the market.
- Systematic traders who are more interested in automatic trading.
Algo Trading Strategies
A mere computer progranmmne cannot help you until and unless you know how to design the programme correctly and you are sure of basis that you want to take into consideration while writing the programme. Now, let us learn the strategies following which you as an individual investor can start algo trading.
Trend Following Stratgies – One can write a programme using moving averages, channel breakouts method, price level movements and other technical indicators related to the scripts. This is the most simple and easiest method of algo trading. With this method, the complexity of price forecasting is eradicated from the system.
Arbitrage Opportunities – When a trader buy a dual listed stock at a lower price in one market and simultaneously sell it in another market at a high price, it is known as arbitrage. By using an algo trading in identification of price differences in the market and thereby placing orders against it will result in profits to the traders.
Apart from the above mentioned most common strategies, several other strategies can also be used viz. Mathematical model based strategies, index fund rebalancing, trading range, volume weighted average price, time weighted average price, percentage of volume and implementation shortfall.
What you need to do algo trading?
In order to use the algo trading to book profits quickly and automatically, you need to have a knowledge of writing a computer program in addition to the knowledge of stocks and market. In case you do not possess that knowledge, then you can seek help from a trading software. Apart from that, you need to have a network connectivity. An access to market data is also required. However, it is important to do backtesting, i,e, testing of the programme or the software on the historical data before actually starting up with the trading in the real market. Therefore, in order to do backtesting, you need to have historical data as well. Backtesting is done for a very simple reason – if there is a flaw in the programme or the software or the data then the entire decision taken on that basis will also go wrong and you can experience a big dig in your pocket.
