| May 08, 2023
Basics of Algorithmic Trading: Concepts and Examples
Are you interested in taking your investments to the next level? Then Algorithmic Trading could be the answer for you. But what exactly is Algorithm trading?
Whether you're an experienced investor, trader, or just getting started, this is an ideal guide for taking your financial skills to the next level. Learn the basics of algo trading and the process of implementing algorithms and using them to make informed decisions about your investments.
With this comprehensive guide to Algorithmic Trading, start gaining insights about making smarter investments and staying ahead of the stock market! Let's get started!
What is Algorithm Trading?
Algorithms, or Algos, are instructions to initiate a specific task. Algorithm trading is a method of executing trades using a computer-generated program known as the Algo trading software, which adheres to a predetermined set of guidelines.
Automated trading systems powered by algorithms generate returns at rates that would be otherwise impossible for human traders. Automated trading is hypothesized to have an advantage over human traders since it can provide earnings faster and more frequently than manual trading.
Instructions based on timing, pricing, quantity, or any other mathematical expression are frequently used by algorithmic traders. Such trading has a reputation for using high-frequency trading equipment, which enables them to execute hundreds of trades every second.
Applications for algorithmic trading methods include order execution, arbitrage, and trend detection. Algorithms can be used to carry out any or all of these tasks.
Basic Concepts of Algo Trading- How does it work?
The goal of algorithm trading is to remove emotion from transactions and to offer the best possible execution. Additionally, it allows for the placement of orders promptly and frequently results in lower trading commission rates.
Understanding algorithmic trading is critical as different investors use trading for various reasons. Algo trading is used by institutional investors like mutual funds and pension funds to make sizable equity investments. They can trade as a result without having an impact on stock prices.
High-Frequency Trading (HFT) is a crucial part of algo trading today, which entails making lots of trades swiftly in various markets with multiple decision inputs based on pre-programmed guidelines. This helps to generate revenues from these investments.
Now that we've got a basic understanding of algorithmic trading let's dive deeper into the core subject.
Mid-to-long-term investors such as pension funds, mutual funds, and insurance companies prefer Algo trading when they want to buy any securities. This helps them move stock prices without relying on discrete and high-volume investments.
Systematic traders like trend followers, hedge funds, and pairs traders have a huge advantage by automating their trading procedures through programming. They can trade more effectively and focus on other things needing attention.
For instance, consider a trader who makes the following two calls:
Purchase 50 shares of the company when the stock's 50-day moving average exceeds its 200-day moving average. Sell any remaining shares as soon as the stock's 50-day moving average falls below its 200-day moving average.
These two straightforward instructions will be used by an algo trading software program to automatically track the stock price and place the buy and sell orders when the predefined parameters are met. The trader no longer needs to manually enter orders or monitor live graphs and pricing. The algorithmic process accomplishes this automatically.
Since algorithm trading depends on data and statistics rather than intuition, it is quickly replacing traditional trading methods for active traders. Traders can make better selections thanks to this methodical strategy's increased market understanding.
Strategies of Algo Trading
A successful algorithmic trading strategy should maximize trading revenues while minimizing trading costs. Arbitrage, mean reversion, market timing, and index fund rebalancing are common strategies. You might also consider additional strategies like pairs trading, transaction cost minimization, and scalping.
Rebalancing of Index Funds - Mutual fund portfolios, including IRAs and pension plans, are frequently adjusted to reflect changes in the value of the fund's assets. Algorithmic trader can earn from anticipated trades by routinely readjusting the asset allocations in an index fund.
The term "rebalancing" refers to this process, which enables them to earn from the number of stocks represented in a certain index. For deals, algorithmic trading algorithms guarantee the greatest pricing, lowest costs, and quickest turnaround times.
Arbitrage and Algos - Arbitrage is a technique used to take advantage of the price variations that may occur due to discrepancies in the value of a security on two different exchanges. This can result in short-term returns for savvy investors.
Whenever a dual-listed stock is available at a discount in Market A and sold at a premium in Market B, you can take advantage of this low-risk arbitrage opportunity and make some revenue.
Traders can benefit from the concept of arbitrage by investing in S and P 500 futures contracts and stocks. Often, there is a difference between the futures price and the total cost of underlying stocks, which can be taken advantage of.
Arbitrage requires meeting three conditions to take place. The same assets mustn't have a uniform price across different markets. Two assets should not be valued similarly if they have the same cash flows.
Every asset carries different risk levels, which can influence their respective prices. Thus, investors must evaluate each asset to determine its market price. Essentially, an asset known to have a certain value in the future should not be bought today at the discounted rate of that same future price, taking into account the risk-free interest rate.
Arbitrage transactions can only be made with electronically traded securities and financial products. These trade operations must take place simultaneously to reduce exposure to the risk of market fluctuations, i.e., where one security's price might change before both trades have been completed.
Mean Reversion - Using the Mean reversion of a stock's high and low prices to create a projected price range is a common strategy in stock investing. This helps investors identify potential buying and selling opportunities.
Technical analysis of stocks involves recognizing the variation in their trading price and computing an average using analytical tools. When the present market value doesn't reach the average cost, it's seen as attractive, hoping the cost will rise.
On the contrary, if the current market prices are higher than the average cost, investors will view it as an unfavorable investment as they expect that price to decrease and return to its usual and average value.
Investors often measure the standard deviation of a stock's recent pricing data to identify potential trading opportunities. Algorithmic trading strategies, such as mean reversion, are commonly used to capitalize on these deviations in stock prices.
Implementation Deficit - By weighing the price of an order against the potential price of delayed execution, the implementation shortfall strategy is effective. By reducing the real-time market execution costs, this tactic saves you both money on the order and earn from missed opportunities due to delayed execution.
The technique will increase the required participation rate when the stock price increases favorably; however, it will drop when the stock price moves negatively.
Market Time - Market timing tactics, which include alpha generation procedures, employ a process that includes live testing, backtesting, and forward testing. Running simulated transactions in an in-sample data period is the first step in market timing, known as backtesting.
After conducting the backtesting procedure, you must optimize for the best outcomes. After that, it's time to move on to the forward testing stage, when you test your algorithms using sample data to ensure they live up to the standards established during backtesting.
Finally, live testing is required to confirm that the transactions are consistent with back and forward tests. Typically, a developer is given this responsibility, and their job is to ensure everything is operating normally.
Benefits and Drawbacks of Algorithmic Trading
Algorithm trading is quickly becoming the preferred approach for active traders since it relies on data and analytics rather than instincts. This systematic strategy gives traders a greater insight into the markets, allowing them to make more informed decisions.
Algo trading brings many benefits to the market, especially regarding liquidity. Brokerages benefit significantly from it due to the order size and faster execution of orders. It is also a great fit for large systematic traders like hedge funds since they can take opposing positions quickly and without issues.
Here are some of the major benefits of Algorithm Trading listed below:
Best Execution - Algorithmic trading is the way forward to ensure that all trades adhere to a set of rules, with an added advantage - attaining the best possible price for these transactions. This helps in obtaining optimum results with reduced effort.
Minimize market impact - Opening large trades can potentially alter the existing market price, resulting in a distortionary trade. To avoid such effects, traders use a 'stepped trading' technique. This involves opening several positions of lesser sizes that cumulatively move the market but do not disrupt it extensively.
Low Latency - Placing orders is quick and accurate, with a high likelihood of being executed at the exact levels you desire. Trade timing is also instantaneous, which helps in avoiding large price fluctuations.
Reduced transaction costs - The costs for transactions are significantly lowered due to automated checks on multiple market conditions simultaneously. It reduces the risk of manual errors and mistakes when trading, allowing you to save time and money. You don't need a human trader that may be influenced by the emotions and psychology of their decisions.
Backtesting - Using both historical and current data, algorithmic trading techniques can be assessed to determine their viability as a circulation method. Backtesting can be used to measure its potential profitability.
Despite the apparent advantages, algorithmic trading has disadvantages as well. Here are some of the drawbacks of Algo trading as follows:
Latency - The speed and latency of algorithmic trading are key factors; delays in trade execution could result in missed opportunities or losses. Therefore, any algorithmic trader should ensure that their order execution is as quick and effective as feasible.
Unpredictable - Algorithmic trading bases its predictions of future financial patterns on historical market data and statistical models. Algorithmic traders, however, are susceptible to unanticipated market disturbances known as "black swan events," which can lead to losses.
Dependence on Technology - A robust technological foundation, which includes computer programs and high-speed internet connections, is necessary for algorithmic trading. Losses may result from technical issues or malfunctions because the trading process is interrupted.
Regulation - Compliance with regulation and monitoring relating to algorithmic trading can be challenging and time-consuming. However, for algorithmic trading to occur, certain conditions must be satisfied.
High startup costs - Developing and maintaining algorithmic trading systems can be expensive. Traders may need to shell out regular fees for software and data feeds in order to keep things running smoothly.
Limited Customization - Because algorithmic trading systems are pre-programmed with predetermined rules and directives, it is challenging for traders to alter them to suit their needs or preferences.
Lack of Human Judgement - Trading algorithms ignore the qualitative and subjective factors that influence market trends because they are highly dependent on mathematical models and historical data. As a result, it might not be able to deduce anything from these factors. Although AIgo trading can provide traders with an analytical edge, it might be a barrier for those who rely on gut and intuition. This is because algorithms lack the human judgment to conclude experience or gut intuition.
Examples of Algo Trading
In 2010, algorithm trading was behind the notorious Flash Crash. It caused a sudden influx of sell orders to be placed instantly on the market, creating chaos and disruption. Quick withdrawals of trade orders for capital and high-frequency trading transactions were also seen.
Regulatory authorities decided to implement circuit breakers to stop a flash crash in the financial markets. These moves also restricted algo-trades from having direct access to the exchange.
Trading algorithms based on moving averages are quite prevalent and surprisingly straightforward. For instance, a 20-day moving average trading algorithm has been implemented in this case.
The algorithm is programmed to purchase Apple stock (AAPL) when the current market value is beneath the 20-day moving average and sell it when it exceeds the same. This helps in making profitable investment decisions.
Visual cues such as a green arrow signify when the algorithm would have purchased stocks, and a red arrow pinpoints the precise moment it sold them.
Is Algorithmic Trading Legal?
Algorithmic trading is fully acceptable and lawful. Trading algorithms are not regulated by any laws or regulations, making them popular among investors. However, some market participants express their concerns that this type of trading could create an inequitable environment and disrupt the operation of markets. It is not against the law to do so.
How Can Algorithms Help You Learn About Trading?
Quantitative analysis or quantitative modeling is crucial to algorithmic trading. If you want to invest in the Indian share market via a trusted stock broking company, you should be familiar with trading and have prior experience with financial markets.
Last but not least, having programming and coding experience would be quite beneficial if you're interested in algorithmic trading. Knowing the fundamentals could offer you an advantage in the sector because technology and computers are essential for algorithmic trading.
Can you earn money using Algorithmic Trading?
Yes, algo trading can be a great way to make money. It offers a systematic and disciplined approach to identifying and executing trades that are much more efficient than manual trading. Plus, it helps traders reduce human errors and enable better market decision-making.
Algorithmic trading has a range of benefits for traders. It enables them to purchase/sell securities at the most suitable prices and ensures that emotional biases do not affect their trading decisions.
Algorithmic trading is becoming a popular choice in today's markets as it helps to ensure that all trades are executed accurately and according to predetermined rules. This allows for more efficient, secure, and reliable trading processing.
Despite the benefits, it's worth noting that algo trading carries its risks and uncertainties, so traders are still likely to experience loss despite having a system in place. Setting up algorithmic trading systems is expensive, making them inaccessible to most traders.
Furthermore, traders must continuously cover costs for algo trading software, and data feeds to keep using them. Investing is a delicate process and should not be taken lightly. Before settling on any decisions, one should, however, research well and take the time to thoroughly evaluate the potential risks and rewards associated with it.