What Are Algorithms?
An algorithm is basically a set of instructions or rules that must be followed by a computer program. They are a lot like a recipe in that algorithms consist of a series of steps that have to be followed in a certain order in order to solve a problem or deliver usable information.
How Are Algorithms Used in Trading?
When it comes to executing trades, the rules an algorithm contains are based on things like price, timing, and stock availability. Algorithms are typically used to monitor the market and then place orders once pre-defined conditions are met. For example, if you want to buy 100 shares of a particular stock, but only once it’s 50-day moving average is higher than its 200-day moving average, you can write an algorithm that can do this work for you without forcing you to watch the stock in real-time.
Most of the algorithmic trading that happens in today’s marketplace is high frequency trading. High-frequency trading, or HFT, is a practice where a high volume of orders are quickly placed across a variety of markets. Decisions like how much to buy or sell along with timing are made by algorithms, not humans, optimizing the process.
What is the Benefit to Algorithmic Trading?
By monitoring the market and identifying the optimal trading times, algorithmic trading has several benefits. The biggest is that trades can happen when prices are ideal, without any need for a human to constantly monitor the market searching for perfect conditions. This gives you the means to time your trades in a way that avoids the risk of significant changes in price.
Algorithmic trading reduces the risk of human-error in trading as well. For example, even something as minor as a typo can have a huge impact on the trade placed. However, when data is entered into a computer and an algorithm determines the trade, there are multiple points where typos can be checked and corrected. Additionally, this style of trading can be tested, based on historic and current data, to determine its viability. Trading based on instinct cannot be tested in the same way.
Another benefit to this style of trading is that it does remove all human emotion from the equation. Emotional and psychological factors, including a person’s bias toward or against a particular stock, can play a shockingly large role in trading decisions; often to the trader’s detriment. Even something as minor as the way you are feeling on any given day can impact how you interact with the market if left to do so on your own.
What are the Technical Requirements?
Before you can dive into the world of algorithmic trading, there are a few technical requirements you must be able to meet. The first, and most important, is computer programming knowledge or the ability to hire a programmer who can create an algorithm tailored to your specifications. Alternatively, you can purchase trading software with pre-made algorithms. Access to multiple trading platforms and a strong internet connection are also key requirements. You want to be sure that your program runs smoothly, collects all the data required, and can conduct the transaction when it is ideal to do so. Dropped connections are one of the biggest reasons for algorithmic trading failures. Finally, you should be sure that you have some historic data to test your algorithm on. This is particularity true if you want to implement a detailed or complex algorithm.
There are a few different strategies that algorithmic traders use to maximize their investments. The most common one examines trends like moving averages and channel breakouts. Trading decisions are then made based on this data. Price forecasts and other predictions are not a part of this approach, which makes it easy and accessible for most traders. Those just starting out with algorithmic trading often begin with this strategy, as it is a great way to introduce yourself to the concept while also participating in the market.
Another popular approach you can use is to examine the market for arbitrage opportunities, where you can buy stocks listed at a low price in one market and sell them at a higher one in a second. This is almost impossible to do on your own. However, you can put an algorithm into place that examines both markets and makes the relevant trades when an opportunity arises.
What Percentage of Trades are Based on Algorithms?
At the moment, almost all trades made in the United States are algorithmic. Recent studies show that this practice accounts for approximately 70 percent of all trades made by US-based investors across all markets. In countries that are considered to be emerging economic powers, like India, the percentage is smaller, at 40, though experts anticipate a 10.3 percent increase in algorithmic trading worldwide between now and 2020. One of the biggest reasons for this shift is the popularity of HFT.
What is the Future of Algorithmic Trading?
Unlike other investment trends, algorithmic trading is probably here to stay, and can work well for just about anyone. Experts believe that the rise in popularity of this style of trading is also going to lend itself to more sophisticated and advanced algorithms, capable of executing very specific rules and instructions. As a result, now is the ideal time to learn about algorithmic trading and how you can put it to work for you.
To learn more or to participate in this type of trading yourself, contact your investment broker today. You can also sign up for trading newsletters, like fractalerts. Fractalerts uses specific trading algorithms that have successfully predicted trading patterns in the past. When you register for newsletters and other communications from companies like these, you can benefit from this math-based approach to trading and may see your portfolio soar as a result.