Algorithm Trading, also popularly known as automated trading, black-box trading, or algo-trading, uses computer programs and algorithms to place a trade. Algorithm trading thus uses computer codes and chart analysis to enter and exit the trade according to specific set parameters like the price movements or the levels of volatility. The trades placed through algo traders can generate profits at a speed and frequency, which is impossible to achieve through a human trader.
Under Algo trading, when the market conditions match the predetermined criteria, the buy or sell order is executed on behalf of the trader. This saves the trader time usually spent on scanning the market, which means that the trades are executed instantly. The instructions that are given under the algo trading are based on timing, price, the quantity of trade, or any other mathematical model. Apart from generating higher profit, algorithm trading ensures more liquidity and more systematic trading. Algo-trading rules out the errors conducted in human trades that are affected by emotions and personal biases.
Why is Algo-Trading More Suitable?
- Algo-trading removes human error as is does not let emotions come into the way of realizing profits or cutting losses.
- Algo-trading can be used to capitalize on unique or rare events that are infrequent and not possible for a human trader to track.
- Algo-trading can be used to fine-tune the risk management in a traders trading strategy. This can be done by implementing stop loss orders and limits on behalf of the trader.
- Algo-trading is cost-effective as the maintenance cost is low. Once the algorithm is set, it lets the trader trade according to their schedule.
- Algorithm strategies can be back-tested and refined in line with historical data. This helps in establishing the best combination of buy and sell parameters.
- The opportunity to generate profit is increased as the trader can choose or create an algorithm according to their strategy and to maximize their exposure to opportunities in the market.
Traders use Algo-trading in many forms of trading and investment activities, including:
- It is used by mid to long-term investors or by buy-side firms for pension funds, mutual funds, and by insurance companies. They use algo-trading to purchase the stocks in large quantities when they do not want to influence the stock price.
- It is used by short-term traders and by sell-side participants of the market such as by speculators and arbitragers who look forward to sufficient liquidity.
- It is used by systematic traders and trend followers and hedge funds.
Algorithm trading is one of the most advanced forms of trading in the modern world. Various algo-trading strategies can help in making the entire trading process more result-oriented as it is fast, accurate, and free from emotional biases.
Though algo-trading is carried out through computer systems, the algorithms are to be generated by the traders, and hence alog-trading strategies play an essential role. Here are some algo-trading strategies that are followed by expert algo-traders.
- Momentum and Trend Based Trading Strategy: Momentum and trend strategies are the simplest of Algo-trading strategies that are widely used by traders. As the name suggests, the momentum and trend strategy follows the trends and momentum to place and execute the trades. The strategy uses technical indicators like moving average and price level movements. The buy and sell orders are executed when the conditions set are fulfilled. This strategy considers historical and current price data to analyze the trend. The decisions are taken based on the fact of whether the trend will continue or not. No complex predictions are made under this trading strategy. The trend strategy states that if a particular asset is moving in one direction for several months, it can be assumed that the trend will continue until the data starts showing the opposite.
- Arbitrage Strategy: Arbitrage opportunities exist when security has a different price on different stock exchanges. Sometimes the same product, like a commodity or currency, can have different prices on different exchanges. Thus, this offers traders an excellent opportunity to make a profit. Arbitrage strategy in algo-trading uses computers to identify the price difference opportunities as quickly as possible for making use of it. With the use of computer algorithms, it becomes easier to track the prices of an underlying asset across different markets and open the trade as soon as possible without any discrepancies. This trading strategy is also not a complex one, but the traders that are quick in responding to the price differences have a distinct edge over other traders.
- Mean Reversion Strategy: Mean reversion strategy is an algo-trading strategy which is based on the fact that the price of the security may go high or low but will come back to an average or a mean value at some point of time. Thus, it is believed that the extreme price movements are on account an overbought or an oversold condition which is likely to reverse. The strategy finds out the upper, and the lower limit of a stock and the algorithms set execute the orders when the prices deviate from the normal range. The algorithm calculates the average based on the historical data of the security. This implies that if the price of the stock is very high, it will come down, and if the price is low, it will go up. This trading strategy is useful when price movements are extreme, and the traders can easily benefit from the unexpected swings in the prices.
- Statistical Arbitrage Strategy: It is a short-term algo trading strategy that is used by traders. The statistical arbitrage strategy is based on the trading opportunities that arise due to price inefficiencies and misquoting of the prices of the securities. This effect occurs in securities that are related to each other or are similar in nature. However, the effect of inefficiency and misquoting is not likely to stay for long. These inefficiencies are corrected in a short duration, and thus algo-trading can easily be used to catch the trend and make profits. The algorithm for this trading strategy uses complex mathematical models that can easily detect the price inefficiencies as soon as possible and execute the trade before the prices of the securities are corrected. A human trader cannot use this strategy; hence it is used in algo-trading. Due to the predefined instructions, the inefficiencies are tracked as soon as possible, and the trade is executed.
- Weighted Average Price Strategy: Weighted Average Price Strategy is one of the most efficient trading strategies that can be based either on the volume-weighted average price or on time-weighted average price. The order, despite being large, is not executed in one go. Instead, they are executed in small parts. The order is released either on the basis of the historical volume profiles of the stock or on the basis of specific pore defined time slots. The objective of this strategy is to reduce the impact on the market by executing the order as close as possible to the volume-weighted average price or to the time-weighted average price.
Multiple algo-trading strategies that can be used while doing trading. The various trading algorithms are designed in such a way that they are compatible with the various strategies. The trader can choose any strategy to execute the trade accordingly. Though algo-trading is computer-based trading, the algorithms are designed by human traders, and thus it is essential for the trader who will define how a trading strategy will perform. The traders can choose any one strategy or a set of strategies based on the market conditions and various other factors.