by Joran Teijema
What is Algorithmic Trading?
Algorithmic trading, also known as automatic trading, uses computer programs that follow a defined set of parameters to place certain trades. In theory, these computerized trades could generate profits at a frequency and speed that is nearly impossible for human traders to accomplish.
These defined parameters are based on price, quantity, timing, or other mathematical models. Besides clear profit opportunities, algorithmic trading renders markets more liquid and trading more systematic by countering the impact of human emotion or bias on trading activities.
Imagine a trader sticks to these criteria:
- Buys 50 shares of a stock when its 50-day moving average goes above the 200-day moving average. (A moving average is an average of past data points that smooths out day-to-day price fluctuations and thereby identifies trends.)
- Sells shares of the stock when its 50-day moving average goes below the 200-day moving average.
Using these two rules, a computer program will automatically monitor the stock prices (and the moving average indicators), and place the buy or sell orders when these rules are met. The convenient thing about this is that the trader no longer has to actively monitor the live prices and graphs, nor do they have to put in the orders manually. The algorithmic model/trading system does this automatically by identifying the best trading opportunity.
Benefits of Algorithmic Trading
Algo-trading provides the following benefits:
- Executes trades at the best possible prices.
- Places trade order instantly and accurately (there is a high chance of execution at the desired levels).
- Times trades correctly and instantly to avoid significant price changes.
- Reduces transaction costs.
- Allows for simultaneous automated checks on multiple market conditions.
- Reduces risk of manual errors when placing trades.
- Algo-trading can be back-tested using available historical and real-time data to see if it is a viable trading strategy.
- Reduces the possibility of mistakes by human traders based on emotional and psychological factors.
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 will use algo-trading to purchase stocks in large quantities when they do not want to influence stock prices with precise, large-volume investments.
- Short-term traders and sell-side participants: market makers (such as brokerages), speculators, and arbitrageurs will 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) will find it much more efficient to program their trading rules and let the program trade automatically.
Algorithmic trading provides a more systematic and organized approach to active trading than methods based on trader intuition or instinct, and has proven to be quite successful in the field.