The Rise of Algorithmic Trading
Written by Bonnie Li on December 2, 2017
Algorithmic trading uses algorithms to place a trade in order to generate a profit at a speed and frequency that’s impossible for human traders.
An algorithm is a specific set of clearly defined instructions for computers aiming to carry out a task or process. Algorithmic trading algorithms are based on timing, price and quantity, and other mathematical models. They aim to utilize advanced and complex mathematical models and formulas to make high-speed decisions and transactions in the financial markets.
Algorithmic trading provides a more systematic approach to active trading than methods based on a human trader's intuition or instinct: it uses fast computer programs and complex algorithms to create, determine, and carry out trading strategies for optimal returns. Before the implementation in the real market, these algos can be tested using past or real time data, in the process of which errors can be identified and future performance can be forecasted.
“Buy 50 shares of a stock when its 50-day moving average goes above the 200-day moving average
Sell shares of the stock when its 50-day moving average goes below the 200-day moving average”
A computer program using these two sets of instructions will automatically monitor the stock price and the moving average indicators, then place the buy and sell orders when the defined conditions are met. The trader no longer needs to keep a watch for live prices and graphs, or put in the orders manually. The algorithmic trading system automatically does it for him, by correctly identifying the trading opportunity.
Benefits of Algorithmic Trading
1. Trades executed at the best possible prices
2. Instant and accurate trade order placement, thereby high chances of execution at desired level
3. Trades timed correctly and instantly, to avoid significant price changes
4. Reduced transaction costs
5. Simultaneous automated checks on multiple market conditions
5. Reduced risk of manual errors in placing the trades
6. Reduced possibility of mistakes by human traders based on emotional and psychological factors
The greatest portion of present day algo-trading is high frequency trading (HFT), which attempts to capitalize on placing a large number of orders at very fast speeds across multiple markets and multiple decision parameters, based on pre-programmed instructions.
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). Many do not seek a profit, they simply try to minimise the cost, market impact and risk in execution of an order. They purchase in stocks in large quantities but do not want to influence stocks prices with discrete, large-volume investments.
- Short term traders and sell side participants (market makers, speculators, and arbitrageurs) benefit from automated trade execution; in addition, algo-trading aids in creating sufficient liquidity for sellers in the market.
- Systematic traders (trend followers, pairs traders, hedge funds, etc.) find it much more efficient to program their trading rules and let the program trade automatically.