What You Need to Know About Algorithmic Trading?

July 27, 2023
10 MIN READ
33 VIEWS
To execute deals at exact times, algorithmic trading integrates computer programming and the financial sector. It often seeks to remove emotions from transactions, provides the most effective implementation of trade, instantly places orders, and may minimize trading expenses. Common trading tactics are trend-following methods, arbitrage possibilities, and index fund rebalancing. Algorithmic trading can also be based on trade turnover (volume-weighted average price) or period (time-weighted average price). To start with algorithmic trading, you will need a computer, a network connection, financial market expertise, and coding skills.

What is algorithmic trading?

Algorithmic trading is a method of implementing orders that uses automated and pre-programmed marketing commands to account for elements including time, price, and volume. A set of instructions for solving a challenge is referred to as an algorithm. Eventually, computer algorithms send little chunks of the entire order to the market. Algorithmic trading makes choices to purchase or sell financial assets on an exchange using complicated calculations, mathematical models, and human monitoring. Algorithmic traders frequently employ high-frequency trading technology, allowing a corporation to execute tens of thousands of deals per second. Algorithmic trading has many applications, including arbitrage, order execution, and trend trading methods.

Perception of algorithmic trading

After computerized trading platforms were launched in American financial markets in the 1970s, the implementation of algorithms in trading proliferated. The New York Stock Exchange (NYSE) created the Designated Order Turnaround (DOT) system in 1976 to route orders from investors to exchange floor experts. In the decades after that, exchanges have improved their ability to handle electronic trading, and as of 2009, computers had conducted up to 60% of all deals in the United States. When author Michael Lewis published the best-selling book Flash Boys, he ignited high-frequency, algorithmic trading to the citizen's focus. The book revealed the lives of Wall Street investors and business owners who contributed to establishing the organizations that came to define the framework of electronic trading in America.

DIY (Do-it-yourself) algorithmic trading

Do-it-yourself algorithmic trading has grown in popularity in recent years. Hedge funds, such as Quantopian, crowdsource algorithms from amateur programmers who contend for commissions for designing the most beneficial code. The technique has been made possible by the widespread availability of high-speed internet access and the emergence of ever-faster computers at low cost. Quantiacs is a platform that caters to day investors who want to experiment with algorithmic trading. Machine learning is an additional emerging technology on Wall Street. Artificial intelligence advancements have allowed computer programmers to create systems that may enhance themselves using a method of continuous improvement known as deep learning. Entrepreneurs are creating algorithms that depend on deep learning to increase their profits.

Working methodology of algorithmic trading

Assume an investor follows the following simple trading standards:

·       When a stock's 50-day moving average exceeds its 200-day moving average, buy 50 shares. (A moving average is a weighted average of previous data points that buffs out day-to-day price volatility and reveals patterns.) 

·       When the stock's 50-day moving average falls below the 200-day moving average, sell shares.

Computer software will consequently track the stock price (and the moving average indicators) and make orders for purchases and sales when the preset circumstances are satisfied using these two simple commands. The investor no longer has to keep track of live prices and graphs or manually enter orders. This is done remotely by the algorithmic trading system by accurately detecting the trading opportunity. 

The pros and cons of algorithmic trading

Pros of algorithmic trading

The main advantages of algorithmic trading include:

·       Greatest Execution

Trades are frequently made at the greatest pricing feasible.

·       Low Latency

Trade orders are placed instantly and precisely (there is a high likelihood of execution at the intended levels). To avoid substantial price swings, trades are timed precisely and promptly.

·       Transaction expenses have been reduced.

·       Automated checks on several market situations at the same time.

·       Free from human err

There is no human error; thus, there is a lower possibility of manual errors or mistakes while placing transactions. Emotional and psychological variables also rule out human traders' proclivity to be persuaded.

·       Back-testing

To determine whether an algorithmic trading strategy is practical, it may be back-tested using accessible historical and real-time data.

Cons

There are multiple challenges or downsides of algorithmic trading to take into account:

·       Latency: Algorithmic trading depends on rapid execution rates and low latency, which is the time it takes for a trade to be executed. If a deal is not completed promptly, it could result in missed chances or losses.

·       Black Swan Events: Algorithmic trading forecasts future market shifts using past data and mathematical models. Unexpected market disruptions, known as black swan occurrences, can result in losses for algorithmic traders.

·       Technology Dependence: Algorithmic trading depends on technology, such as computer programs and high-speed internet access. Technical problems or malfunctions can interrupt the trading process and lead to losses.

·       Large algorithmic transactions can greatly influence market pricing, resulting in losses for investors who cannot modify their bets in reaction to these fluctuations. Algorithmic trading has also boosted market volatility and sometimes caused flash crashes.

·       Algorithmic trading is bound by various regulatory regulations and monitoring, which can be complicated and time-consuming to meet.

·       High financial costs: Developing and implementing algorithmic trading systems can be expensive, and traders may be required to pay continuing fees for software and data feeds.

·       Limited Customization: Because algorithmic trading systems depend on predetermined regulations and guidelines, dealers' capacity to tailor their trades to match their needs is limited.

·       Lack of Human Judgment: Because algorithmic trading is based on mathematical models and historical data, it does not account for the subjective and qualitative aspects that might impact shifts in the market. This absence of human judgment might harm investors who favor a more emotional or impulsive trading style.

Time scales of algorithmic trading

High-frequency trading (HFT), which seeks to take advantage of executing a significant number of orders at quick rates across numerous markets and decision factors based on pre-programmed instructions, accounts for most algorithmic trading today.

Algorithmic trading is utilized in a variety of trading and financial operations, such as:

·       When mid- to long-term traders or buy-side firms—pension funds, mutual funds, insurance companies—do not aim to affect stock prices with independent, large-volume transactions, they utilize algorithmic trading.

·       Short-term investors and sell-side participants like market makers (such as brokerage houses), speculators, and arbitrageurs; gain from automated trade execution; also, algorithmic trading contributes to providing adequate financing for market merchants.

·       Systematic traders, such as trend followers, hedge funds, or pairs traders (a market-neutral approach to trading that complements a long position with a short position in a pair of highly linked instruments such as two stocks, exchange-traded funds (ETFs), or currencies), find it far more effective to program their investment regulations and let the program commerce automatically.

Algorithmic trading offers a more systematic strategy to active trading than approaches relying on investor insight or emotion.

Approaches of algorithmic trading

All algorithmic trading technique necessitates the identification of a favorable opportunity in terms of increased revenues or cost reduction. The following are some of the most prevalent trading methods utilized in algorithmic trading:

1.     Trend-following techniques

Moving averages, channel breakouts, price level fluctuations, and associated technical indicators are algorithmic trading systems most often used. Since these methods do not require any predictions or price projections, they are the easiest and simplest to apply using algorithmic trading. Transactions are made in response to the emergence of favorable trends, which are simple and easy to apply using algorithms without delving into the complexities of predicting outcomes. A popular trend-following method is to use 50- and 200-day moving averages.

2.     Opportunities for arbitrage

Purchasing a dual-listed stock at a lower price in one market and concurrently selling it at a higher price in another market results in a risk-free profit or arbitrage. As price differentials arise occasionally, the identical technique may be performed for stocks vs futures products. Implementing an algorithm to detect such price differentials and effectively placing orders provides good chances.

3.     The rebalancing of index funds

Index funds have rebalancing periods to align their investments with their respective reference indexes. This generates attractive chances for algorithmic investors, who earn from predicted transactions that yield 20 to 80 basis points gain based on the number of securities in the index fund right before rebalancing. Algorithmic trading algorithms conduct such transactions to ensure prompt implementation and the best pricing.

4.     Approaches based on mathematical models

Proven mathematical methods, such as the delta-neutral trading technique, enable trading on options and underlying securities. (Delta neutral is an investment approach consisting of various positions with offsetting positive and negative deltas—a ratio that compares the shift in the price of a security, typically a marketable asset, to the related shift in the cost of its derivative—so that the complete delta of the assets in question equals zero.)

5.     Mean reversion 

The mean reversion method is based on the idea that an asset's high and low values are only transient and will eventually revert to its mean value (average value). Determining and establishing a price range and creating an algorithm based on it enables trades to be conducted automatically when the cost of an asset falls in and out of its stated range.

6.     Time-weighted average price

The time-weighted average pricing technique divides a large order into smaller parts and delivers them to the market in dynamically set time windows between a start and finish. The goal is to execute the order around the average price between the beginning and conclusion timings, reducing the market effect.

7.     Volume-weighted average price (VWAP)

Using stock-specific historical volume profiles, the volume-weighted average pricing technique splits up a big order and delivers dynamically determined smaller parts of the order to the market. The goal is to complete the order around the volume-weighted average price (VWAP).

8.     POV (Percentage of volume)

The approach continues delivering partial orders based on the defined participation ratio and the volume transacted in the financial markets until the trade order is filled. The associated "steps strategy" sends orders at a user-defined percentage of market volumes, and this participation rate rises or lowers when the stock price hits customized thresholds.

9.     Implementation deficit

The implementation deficit technique reduces an order's operation expense by trading off the real-time market, saving money on orders and profiting from the opportunity cost of delayed execution. The technique will raise the desired level of participation when the stock price rises and lower it when the stock price falls.

Algorithmic trading technical prerequisites

The last component of algorithmic trading is the implementation of the algorithm using a computer program, which is accompanied by back-testing (checking out the algorithm on historical periods of prior stock-market performance to determine if utilizing it would have been lucrative). The task is to convert the outlined approach into an integrated automated procedure with access to a trading account for placing orders. The prerequisites for algorithmic trading are as follows:

·       Accessibility to market data sources that the algorithm will track for chances to place orders.

·       Access to market platforms and network connections to place orders.

·       Depending on the intricacy of the regulations used in the algorithm, historical data availability for back-testing.

·       The capacity and technology to back-test the system once it has been constructed before going live on real markets.

·       Computer programming skills are necessary to program the appropriate trading strategy, which professional programmers can do or already assembled trading software.

Is it legal to trade algorithms?

Algorithmic trading is permitted. Any regulations or laws do not restrict trading algorithms. Some investors may argue that this trading style generates a biased trading environment that harms market performance. Nevertheless, it is not unlawful in any way.

Conclusion

Algorithmic trading combines computer software with financial markets to open and close deals using predefined code. Investors and dealers may control when deals open and close. They can also use processing power to engage in high-frequency trading. Algorithmic trading is common in financial markets today, with various tactics available to traders. Gather computer hardware, programming expertise, and financial system experience.