A Guide to the Basics of Algo Trading
Algo trading is exploding with recent statistics suggesting that between the years 2021 and 2026, it is growing at a CAGR of 11.23%.
Why is algo trading such a big phenomenon for investors and traders? For one reason, it takes away some of the guesswork you often perform when trading stocks. Another reason is that it makes the process a lot quicker.
To better understand what algorithmic trading is, and how it works, keep reading. What it does, and the potential for what it can do, are simply amazing.
Here are mind-blowing details on algo trading.
What Is Algo Trading?
When you use software and computer code to open and close trades, this is the algo trading definition. Algorithmic trading leverages software and computer code to set rules. For instance, you can set it for the point of price movement in an underlying market.
If the conditions of the current market match any of the criteria which are predetermined in your set rules, algo trading will execute an order on your behalf, either a buy or a sell. Leveraging algorithms and coding are a great way to save time while trading. You no longer need to manually scan the markets.
Automation in Trading
Algo trading strategies are essential approaches that are automated. It’s a faster method for placing and executing orders. It employs a framework that is rule-based, which covers items like:
- Managing risk
- Selecting trade instruments
- Filtering trading opportunity
- Adjusting position size
Algorithmic trading is a significant change in the process of trading and the associated research that comes with it, all with the help of artificial intelligence. You may also hear terms like a mechanical, systematic, bot, and quantitative trading when referring to algorithmic trading.
Who Uses Algo Trading?
Usually, you find an automated approach like algo trading for HFT or high-frequency trading. This allows such investors to capitalize while placing many orders quickly with multiple decision parameters and multiple markets.
Buy Side Firms or Mid to Long-Term Investors
Groups such as these could be insurance companies, pension funds, and mutual funds. Firms and investors like these can benefit from algo trading because they will typically buy stocks in large quantities. However, they want discrete, large-volume investments because they do not wish to influence stock prices.
Sell-Side Participants and Short-Term Traders
Speculators, arbitrageurs, and market makers like brokerage houses can benefit from algorithmic trading, too. Not only that, but algo trading helps sellers create enough liquidity in the market.
Systematic Trader
Pairs traders, trend followers, and hedge funds find that programming their trading rules is more efficient. Also, the program will automate their trades.
What are pairs traders? This refers to a market-neutral strategy where one seeks to correlate a long position alongside a short position.
They must be a pair of highly matched instruments like two currencies, stocks, or ETFs (exchange-traded funds).
How to Trade
Often, you hear people compare trading to gambling. That is because trading and gambling have many similarities between them. Just like gambling, with trading, you want to increase your odds of success.
Trading is more a form of educated gambling, however, because it should entail a lot of research. This is why algo trading is so valuable because it can help you research realistically and efficiently, which you will read about shortly in this article.
However, here are the basic steps you must take to begin trading.
- Open a trading account
- Learn to read and take a market crash course
- Learn to analyze
- Practice trading
- Keep learning about trading and keep practicing
A mentor can be tremendously beneficial to help you learn about trading. If you have a hands-on coach who can help you, offer advice, and critique your strategies, lean on them as much as you can. You could buy a mentor too through an online trading school or program.
Why Use an Algorithm?
Algorithmic trading is not new. It’s been around since the early 1980s. Back then, algo trading strategies were on a punch card.
Today, in the modern era, algo trading executes a lot faster and is lowering the cost of trading. However, there are still critics who dislike it, saying that algo trading leads to market instability. There are fears it could attribute to a major crash.
Despite what naysayers believe, algo trading has a lot of benefits.
Minimizes Emotion
Anything one can perform manually means that a human is performing it, and humans develop feelings toward something, one way or the other. Algo trading takes away emotions that could negatively affect the trading process. Emotions could cause over-trading.
Actions are only from strict and predefined rules. Automating can eliminate a potentially negative outcome because of trading, which is excessively based on emotion.
Accuracy
When placing trades by hand, a human can make a human error. Automation from algo trading eliminates that risk.
Further, calculations in trading can be complex. With an automated approach, it is much simpler for a trader or investor to perform a complex calculation.
That said, a human sets the rules and instructions for which algo trading executes itself. While you can reduce errors, you should also ensure that you are making the best trade decisions. You can enhance and improve the accuracy of your trading transactions if you plan accordingly.
Systematic
The asset selection process is automated. This makes everything from entry, exit, asset selection, and order executive systematic. It is a step-by-step instruction of execution that will perform with no aid from a human.
Provides Consistency
Algorithms are methods that are automated, and automation is how to be consistent. Preparation and execution of trading are challenging.
You can have a profitable trading strategy, but it will not work unless there is follow through. A trading plan needs proper action and tracking. If you are not tracking your progress, your plan can fall apart.
Less Volatility and Reduced Costs
Algo trading prevents significant price changes because they time trade instantly and correctly. Further, transaction costs come at a reduced price, too.
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Faster Speed
Many times, a trading strategy also needs to be executed on time. If you are late, you are potentially losing out on profits. The market will not wait all day for you.
This can be the most helpful benefit of algo trading because you get incredible speed. You can buy and sell faster than point-and-click trading. The speed at which you can execute your orders comes down to the leanness of your code, not your fingertips or waiting for your eyes to blink.
Scope of Trading
Plus, algo trading allows you to cover more markets. One trader on their own, or a team of traders at that, can find it difficult to track every individual stock or each instrument. Particularly if you have algo trading strategies that run across asset classes.
Since algo trading is rule-based and automated, it applies the same trading rules to as many asset classes and instruments as you need it to.
Potential Downsides to Algo Trading
Computers and automation make far fewer mistakes than humans do. However, they could still break.
There could be a power outage, issues with Internet connectivity, and exchange latency, not to mention, that a computer could crash. Depending on when the issue occurs, it has the possibility of being a problem of catastrophic proportions.
A Bug in the Coding
With coding, there is always the potential that there is a fluke that requires correction. It is hard to find a bug at times, and you might discover it after it is too late, unfortunately.
Perhaps because of an error, an order is wrong. It goes to the wrong market and in the wrong size.
Testing is critical to avoid such issues. This means conducting both back testing and forward testing must with a demo environment and with real orders, too.
Algo Trading Strategies Versus Actual Results
Have you ever seen a disclaimer to the effect of past results do not show future results? The market is constantly changing and fluctuating. What was working for you yesterday, you cannot expect to work tomorrow.
A pattern you notice in the past could never repeat in the future. Another possibility is that a pattern could be so rare, that it would never be profitable for you, anyway.
Test Your Trading Algorithm
An enormous benefit and a crucial weapon for using an automated approach with computer coding is the ability to test an algo trading strategy. The most common method of evaluating performance is through backtesting.
You can replay historical data with a simulator. This can be from fundamental data, price, order flow, or a combination of factors.
Backtesting is how a trader can take a closer look at what happened in the past to see how a strategy could have performed had it been used.
Still, there are traders who would rather focus on the future. This way, they can prevent the risk of over-optimization. Forward testing is an algo trading strategy that is performing in a live market environment.
Backtesting
If you have a hypothesis for your algo trading strategy, you want to evaluate your theory to see if it will work. You can use historical data, and this you refer to as backtesting.
Many savvy algo traders will not risk capital in a live environment without first backtesting. They can discover various outcomes to better plan for the future.
Forward Testing
This is a method to test performance but with a distinct set of samples of data, and analyze the system. With forward testing, you are testing the system’s logic in real-time.
You also hear people call it paper trading. This is because the trades in forward testing are only on paper.
“Paper trading” logs trade entries, exits, profits, and losses. However, you are not performing actual trading.
Backtesting Versus Forward Testing
The biggest difference you see is that backtesting is the first step to discovering a system’s effectiveness. Forward testing, though, will offer additional results. It will assess an algo trading strategy’s accuracy.
When it comes to creating winning algo trading strategies, you need both. Backtesting and forward testing are essential, even though some traders will weigh more heavily on one or the other.
The Risks of Trading Algos
A drawdown measures a decline, starting from a historical peak. It is the biggest trough in the returns for the trading strategy.
You usually see a drawdown as a percentage of capital. No matter your algo trading strategies, you will experience a drawdown at one point in time.
A perfectly profitable strategy all the way from the very first trade is likely to have a small drawdown at the beginning of the commission on the trade.
Just like an asset, a portfolio will incur multiple drawdowns over time. From peak to trough, the maximum loss is the maximum drawdown. Well, until a new peak occurs, that is.
Ready to Try Algo Trading?
Once you get your feet wet and you understand the basics of trading stocks, algo trading strategies can help. The ideas in this article are just some of the ways algo trading can help you. There are no one-size-fits-all answers, so the possibilities of algo trading are limitless.
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