Basics of Algorithmic Trading
Algorithmic trading (also called automated trading, black-box trading, or algo-trading) uses a computer program that follows a defined set of instructions (an algorithm) to place a trade. The trade, in theory, can generate profits at a speed and frequency that is impossible for a human trader.
The defined sets of instructions are based on timing, price, quantity, or any mathematical model. Apart from profit opportunities for the trader, algo-trading renders markets more liquid and trading more systematic by ruling out the impact of human emotions on trading activities.
Algorithmic Trading In Practice
Suppose a trader follows these simple trade criteria:
- Buy 50 shares of a stock when its 50-day moving
average goesabove the 200-day moving average. (A moving average is an average ofpast data points that smooths out day-to-day price fluctuations and therebyidentifies trends.)
- Sell assets when its 50-day moving average goes below the 200-day moving average.
Using these two simple instructions, a computer program
Benefits of Algorithmic Trading
Algo-trading provides the following benefits:
- Trades are executed at the best possible prices.
- Trade order placement is instant and accurate (there is a high chance of execution at the desired levels).
- Trades are timed correctly and instantly to avoid significant price changes.
- Reduced transaction costs.
- Simultaneous automated checks on multiple market conditions.
- Reduced risk of manual errors when placing trades.
- Algo-trading can be backtested using available historical and real-time datato see if it is a viable trading strategy.
- Reduced possibility of mistakes by human traders based on emotional and psychological factors.
Most algo-trading today is high-frequency trading (HFT), which attempts to capitalize on placing a large number of orders at rapid speeds across multiple markets and multiple decision parameters based on preprogrammed instructions.
Algo-trading is used in many forms of trading and investment activities including:
- Mid- to long-term investors or buy-side firms—pension funds, mutual funds, insurance companies—use algo-trading to purchase stocks in large quantities when they do not want to influence stock prices with discrete, large-volume investments.
- Short-term traders and sell-side participants—market makers (such as brokerage houses),speculators, and arbitrageurs—benefit from automated trade execution; in addition, algo-trading aids in creating sufficient liquidity for sellers in the market.
- Systematic traders—trend followers, hedge funds, or pairs traders (a market-neutral trading strategy that matches a long position with a short position in a pair of highly correlated instruments such as two stocks, exchange-traded funds (ETFs) or currencies)—find it much more efficient to program their trading rules and let the program trade automatically.
Algorithmic trading provides a more systematic approach to active trading than methods based on trader intuition or instinct.
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