What is Algorithmic Trading? Things to Keep in Mind while doing Algo Trading

Last updated:
What is Algorithmic Trading?

Algorithmic Trading: An Overview

Human life is more reliant on artificial intelligence than ever before. According to research done by the University of Georgia, mankind trusts computers more than humans. You can imagine how human life is surrounded by technology and so do investors/traders in the stock market. Algorithmic trading also known as Algo trading allows traders and investors to trade in the stock market using computerized rules. Algo trading came to India in 2008, but only a few people were aware of it. It was introduced to automatically execute large numbers of market trades at accurate time and speed which cannot be done by humans. 

What is Algorithmic trading?

Algo trading means the process of carrying out market orders by applying a pre-planned set of rules subject to price, quantity, and volume. Algorithmic trading is possible because it uses an algorithm or formulas that contain a defined set of rules to execute the trade. The purpose of Algo trading is to assist investors and traders to execute trades at accurate prices and speed to achieve higher profits. In India, there is a rapid increase of using algorithmic trading platforms. 

Algorithmic Trading in Practice

Trading algorithms place large orders. They are handled manually—market liquidity. Mistakes arise when thousands of employees order simultaneously.

Algorithmic trading trumps human order-taking.

  • The speed at which an algorithm can place an order helps achieve competitive pricing and immediate delivery. First-movers may buy or sell before everyone else.
  • Algorithms save time and resources so traders may focus on other duties, such as analyzing data, instead of placing orders manually one by one (which is literally where we got steel).

Algorithmic Trading Strategies

There are several types of algorithmic trading strategies. Each algorithm is created to achieve a specific goal.

The following are some of the most popular algorithmic trading strategies:

  • Trend following strategy
  • Mean reversion strategy or mean-reverting Algo trading
  • Arbitrage strategy (e.g., butterfly spread)
  • Momentum missive Algo trading

A computer buys, sells, or holds assets based on preprogrammed instructions. Multiple data streams are used.

Market Making, Statistical Arbitrage, and HFT are algorithmic trading.

Market makers purchase and sell (known as liquidity). You leverage inventory to profit from buying-and-selling price discrepancies. This involves keeping detailed records of each transaction, so you know how much profit or loss was achieved on each trade order submitted by traders who want speedy access to your stock prices via their platforms or from someone who does.

Technical Requirements for Algorithmic Trading

Online PC for algorithmic trading. Rent a computer for $1000 a month or use your own.

Several services allow you to construct bots on their servers. Tradeworx and Quantopian are two.

An algorithm determines the programming language. Python is shorter than C++ (and thus has fewer bugs). R trumps C++ because it has built-in statistical libraries.

Data Feed: You should receive market information from an external source such as Bloomberg Terminal or Interactive Brokers because they provide the best quality real-time data feeds that include futures prices. Yahoo Finance and Google Finance lag by several minutes, making them useless since trading decisions cannot be based on stale information, only on time stamps.

Is Algorithmic Trading Legal?

Legalizing algorithmic trading Few countries prohibit algorithmic trading. Illegal insider trading might affect your blog.

Some deals involve insider trading. An algorithm delivers trading signals (which may alert others). This might constitute insider trading if others benefit from their information beforehand or the market is improperly influenced.

Most algorithmic trading is lawful (and was before HFTs), but front-running or insider trading may be criminalized (where someone has access to inside information and uses an algorithm based on that information).

Algorithmic Trading Meaning: Key takeaways

  • Algo trading allows big investors and traders to manage their trading in enormous numbers. 
  • It uses computerized programming or formulas in the stock market to carry out buying and selling orders at accurate times. 
  • It is used to execute a huge number of orders without the involvement of humans. 
  • Algo trading meaning is to execute numerous trades so that they can earn high and quick profits from the stock market, crypto market, and forex market. 

How does Algo trading work?

Algorithmic trading works on coded instructions and formulas. The entry and exit trades are fully automated and are popularly used by traders who are into scalp trading. Scalp trading is done with the help of technical analysis and it involves rapid buying and selling of shares. 

The most important step for algorithmic trading is to have the right strategy that is back-tested well because the success rate of trade relies mostly on the effectiveness of the strategy. After developing a suitable strategy, you need to convert this into an algorithmic program and once the algorithmic program is examined by the exchanges, it is good to go. Let's understand this with an example, if you want to buy 1000 shares of a company ABC when the price goes above Rs. 100 and it reaches Rs. 100, with every point increase, you will buy 10 shares or with every point decrease, you will sell 10 shares. In such a situation, you have to stick to the screen throughout the market hour to track the company's stock price. However, if you have programmable software, it will execute all your orders. All you need to do is code the instructions to generate buy and sell alerts wherever there is a buy or sell signal. 

What are the Benefits of Algo trading?

  1. The biggest benefit of using algorithmic trading is speed. The orders are executed within a fraction of seconds which is not possible for a human and the speed is so accurate that it allows executing the trade at the exact price. 
  2. With the help of algorithmic trading, one can use multiple indicators and carry out orders that no human can do. Also with faster analysis and execution, traders get more opportunities to trade. 
  3. Since the algorithms are properly checked, Algo trading becomes more accurate. The trade gets automatically executed which avoids the risk of wrong trade. 
  4. Usually, investors take irrational or stupid decisions while making investment decisions because most of the decisions made by humans are driven by emotion but in the case of Algo trading, there is no human emotion involved while executing trades. Once the algorithmic programs are set, the trades are executed automatically and it helps you to inculcate discipline trading. 
  5. The transaction costs are comparatively lower and save a lot of time as it can execute a large number of traders within a short time. A trader doesn't have to glue to their screen throughout the market hour to track the price. 
  6. Algo trading helps in increasing the liquidity of the market as it allows you to trade a large volume of shares within a few seconds. 

Things to keep in mind while doing Algo Trading

  • Traders have to rely on technology to trade. There can be a risk of failure of the system or a weak internet connection which is a major disadvantage of Algo trading. 
  • One single fault in the algorithm can make you lose a hefty amount of money on a single transaction. 
  • There is no control of humans in Algo trading as it is fully automated. Once the strategy is coded with instructions, a trader can't stop the trade even if he realizes later that the strategy will not work. 
  • Traders have to monitor the system to ensure that there are no duplicate or missing orders. 
  • Traders have to continuously work on their technical skills to develop the algorithms. 

To concludeAlgorithmic trading helps you to increase your profitability while trading in the stock market.  However, it is associated with risks and obstacles such as system failure, disruption in internet connection, and wrong algorithmic instructions.  So, before starting algorithmic trading, you should have experience in trading in the stock market by using technical analysis tools. Also, you need to have a lot of patience, do a lot of market research, code algorithms, and backtest your strategy and resilience to become a professional trader. 

Advantages of Algorithmic Trading

Algorithmic trading benefits:

Faster execution: Algorithmic trading uses computer algorithms to assess market data and make orders. A human trader may take seconds or minutes to answer, whereas an algorithm will instantly make a decision. This is particularly helpful in turbulent markets when prices might move fast, and your broker may not react soon enough.

Reduce transaction fees: Lowering the time between submitting an order and executing it decreases expenses since there's less danger in holding assets until they're sold at a profit (or loss). If you're acquainted with Walmart or Target, you know how costly it is to stock shelves and pay people. Automated traders aren't paid unless they're successful; thus, there are no additional costs (for example, taxes).

Disadvantages of Algorithmic Trading

  • Algorithmic trading is beneficial for most individuals, but not always. An algo trading method involves costly and complex technology. Complex strategies might take a long to implement.
  • Algorithms are supposed to reduce risk, yet they still have dangers. Algorithms may be unpredictable and erratic, leading to losses without attentive trader control (or by your broker).
  • Many traders may find algorithmic trading challenging because they lack the cash and expertise to pay for such services.
  • What is the risk associated with algorithmic trading?

  • Who can use Algo trading in the stock market?

  • Can algorithmic trading be profitable?

  • How can I start algorithmic trading?

  • Can a retail investor do algorithmic trading?

  • Which is the best strategy for algo trading?

  • What are the risks of algorithmic trading?

  • Is algo trading always profitable?