Algorithmic trading or “algo trading” utilizes sophisticated algorithms – customized computer programs designed by traders to automate their trading strategies. Contrary to manual stock trading, in which the trades are placed through the input of a human trader, algo trading does not depend on the human factor. The algorithm automatically carries out the trading decisions set out by the trader, thereby saving time, energy and reducing errors.
Due to its efficiency and consistent performance, algorithmic trading has seen a remarkable surge in popularity amongst traders, including novice traders. By combining the power of technology with an encompassing knowledge of investment strategies, the farsighted trader can employ algo trading to their advantage. This article will outline the basics of algo trading, discussing strategies, setting up an algo trading system and keys to successful trading.
Understanding Algorithmic Trading
Algo trading is the use of automated systems guided by mathematical models, running complex trading strategies across large volumes of data, to identify opportunities in the market and execute trades. The key feature of algo trading is it facilitates rapid-fire decisions based on market conditions. With access to pricing data and trading algorithms that can analyze and perform transactions within a fraction of a second, algo trading is geared towards maximizing profits and minimizing losses.
Examining Strategies for Algo Trading
Algorithmic trading remains a tightly guarded secret amongst many traders, but the potential impact of algo trading on the investor’s portfolio cannot be overlooked. Novice traders could benefit from a variety of algo trading techniques such as statistical arbitrage, momentum trading, value based investing and market making.
Statistical Arbitrage – Statistical arbitrage looks for short term mispricing opportunities in the market through price correlations between different securities. This strategy works as long as your trading system is able to identify pricing discrepancies quickly.
Momentum Trading – Momentum traders are capitalizing on short-term buying or selling trends. This trading strategy usually focuses on stocks which have moved significantly in the last several days or weeks and whose momentum is expected to continue.
Value Based Investing – Value-based investing is a stock selection technique that emphasizes stocks whose current market prices do not reflect its intrinsic value. This approach to trading involves predicting the price of a security when it reaches its true value.
Market Making – Market makers use both buy and sell orders to make profits by providing liquidity to the current trading pool. They use algorithms to detect subtle changes in the spreads between the buyer’s bid and the seller’s asking price.
Establishing an Algo Trading System
To set up an algo trading system, the first step is to determine the trading objectives, followed by selecting the appropriate programming language to write the trading code. After incorporating the desired features into the code, the system needs to be validated with back testing. Finally, the system needs to be properly deployed, monitored and optimized for performance.
Reaping Benefits of Algo Trading
Algorithmic trading has revolutionized the way traders invest money in the stock market. Traders who choose to go down this route stand to benefit from a wealth of advantages: it saves time, eliminates emotions from decision making, executes a high number of trades, evens out the playing field for smaller investors and offers opportunities for high frequency trading.
Despite the advantages algo trading offers, traders must bear in mind that an automated trading system is merely an extension of the trader’s own trading strategies. To reap maximum rewards, the system needs to be tailored to the trader’s individual needs and goals. When used wisely, algo trading can be an invaluable tool in the toolkit of novice traders.