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Algo Trading | August 18, 2023

How to benefit from algorithmic trading using automation tools and an approach to navigate market volatility

Stock markets are bound to be volatile, that is what traders and investors encash, isn’t it? However, with high volatility in the market, it becomes difficult to trade, right? Human emotions come to play as well in highly volatile markets and that mainly forces traders to lose money in the market. Here comes the core benefit of algorithmic trading which will discuss in this article.

What is algorithmic trading?

Algorithmic trading can be defined as a trading method where the trades are executed based on pre-determined criteria, which can include price movement, price points, market volatility, and other factors. When a computer is fed with a certain set of programs (read algorithms) to buy or sell stocks or any other securities in the stock market, it is known as algorithmic trading or Algo trading.

At present, the Algo trading penetration level in India is around 50% to 55%, which means half of the traders use algorithmic trading methods and strategies for daily trading. Though the figure seems quite impressive, however, when compared with countries like USA or UK, it is still at a lower level. In the USA, the algo trading penetration level is around 85%.

These figures must have made you curious as to why so many traders are opting for algorithmic trading, hasn’t it?

The answer is quite simple and that is the ease of trading in volatile markets with different algo trading strategies.

How algorithmic trading helps in navigating uncertainty in the stock market?

The prices in the stock markets change in seconds or even in less time than that. When the market is highly volatile, it does not even take milliseconds to change. Therefore, trading in such an environment takes a lot of skills, experience and most importantly the right strategy, and patience. However, even if you achieve these qualities, when the markets are in turmoil, even a second’s gap can lead to losses. With Algorithmic trading, however, you can reduce the chances of those losses, which you would have incurred with manual trading.

As machines (read computers) can execute trades faster than human hands if the humans feed the machines with the right set of criteria. When a person trades manually, it at least takes a few seconds to place a trade, right but the markets don’t wait so the price can change and that can lead to losses or leave the trade without placing the order.

This is what algorithms change. For instance, the market is highly volatile today, but you are expecting the prices of stock A to go up to Rs. 2000 and currently, it is trading around between Rs. 1800 and Rs. 1950 as the markets are highly volatile. Now you want to buy the stock at around Rs. 1850, so you can set up the algo trading platform of yours and set the buying price as Rs. 1850 and when the price touches this amount, your trade will get executed.

Since, in a highly volatile market, the prices move very fast, it becomes almost impossible to buy or sell the securities at the price you want to. However, with pre-determined programs, which algorithmic trading uses, it becomes feasible.

Algorithmic trading also helps in removing human error, which is highly common during high market volatility. If you are manually trading, then you have to enter the price and units of the stock you want to buy as, and when you are placing the trade. Now since the market is highly volatile, prices are moving drastically, right and during such fast movement, placing a trade can lead to errors like incorrect price entries or units you want to trade.

With Algo trading, these human errors can be put aside and you can feed your criteria well in advance so that you neither miss out on any opportunity, nor errors occur during order placing which can lead to losses.

Another important factor that algorithmic trading helps in a volatile market is human emotions. Traders, especially newbies often get carried away by market volatility if trading manually. However, with algo trading strategies, one can get a grip over their emotions and trade wisely. This is crucial in a volatile market.

Strategies used in algorithmic trading

Algorithmic trading revolves around certain strategies using different algorithms. Some of the common kind of strategies include –

  • Price Action strategy: In this strategy, orders get triggered when the price of the security trades around the open and close or session high and session low of the previous trading session. For using this strategy, you first need to determine whether you want to buy or sell the security. Then you need to design the algorithm in such a way that if the price moves above Rs. A (suppose) then buy order will be triggered and if the price moves below Rs. B, then the selling price will be triggered. This strategy is the most common algo trading strategy in highly volatile markets and is thus counted amongst high-frequency trading strategies. This strategy is suitable for traders who are looking for small profits in a highly volatile market but on a constant basis. While the above criteria such as open or closing price are just basic ones, you can modify your strategy as per your trading plan too.
  • Technical analysis Strategy: The next up is an algo trading strategy that revolves around technical analysis. This strategy can be designed with different technical analysis tools such as MACD, Bollinger bands, RSI and others. A strategy designed with Bollinger bands can be highly useful in a volatile market. This strategy can be used to open or close a trade order.
  • Momentum and Trend Strategy: In this strategy, one can use momentum and market or price trend to design and set the algorithms. The historical trends and momentum data are used here and if the current market resonates with the historical momentum ad trend, then trades get triggered.
  • VWAP strategy: Using Volume Weighted Average Price as the criteria, this strategy is built. In this strategy, bulk order is segregated into small orders and then traded dynamically in the market.
  • Statistical Arbitrage Strategy: Arbitrage is one of the common methods of trading in the stock market by daily traders, where they benefit from little gaps in prices of the same stock on different exchanges. Suppose stock A is trading on NSE at Rs. 100 while it is trading on BSE at Rs. 101. Therefore, the traders using the arbitrage method can encash this gap. Now, a human eye and brain cannot continuously look for such opportunity, thus algo trading helps here.
  • Combination strategy: This strategy makes use of price action as well as technical analysis to make sure price movements in the market and potential. Then algorithms are built and entered to place buy or sell orders. Here also, historical prices are crucial and you need to analyse them to build this combination strategy. Along with historical prices, you need to be aware of and have an in-depth understanding of technical indicators. In this strategy also, you need to decide whether to go long or before you start with the strategy and accordingly use the algorithms to design.

While the above strategies are the most common and effective ones in a highly volatile market, there are other algo trading strategies too, which you can use as per your trading requirements and plan.

Things to remember while using Algorithmic trading strategies

While algorithmic trading can be useful during volatile market conditions, there are certain things you need to take care of while using these strategies.

  • The algorithms developed by you or any trader are short-lived. As the market changes frequently, most of the algorithms need to be altered other they would not remain useful and can even lead to losses.
  • While machines can act faster and place orders immediately when the criteria are met, without human control, these algorithms won’t work or get developed. Therefore, human intervention is mandatory and crucial.
  • Make sure you do not over-optimize algo strategies as that can result adversely.
  • For developing algorithms, coding or programming knowledge is required to a certain extent.
  • For buying an algo trading platform, you need to invest a significant amount initially.

Final thoughts

Sailing through the rough waters of the stock market is tough, even for professional traders. While the volatility in the stock market is natural, and that is what offers the returns, traders need to adopt methods and strategies to sail through volatile times. Algorithmic trading offer support to the trader on which they can rely and take part in the highly volatile markets.

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