Algorithmic trading is a type of computerized trading that uses mathematical formulas to determine the optimal time and price to trade stocks, currencies, commodities, and other assets. Algorithmic traders use these formulas to generate high-speed automated trades across many markets at once by analyzing real-time market data. This article will discuss how algorithmic trading works and what you should know about it.
How Algorithmic Trading Works?
The first step in the process is to develop a trading algorithm. It can be done by hand, but most traders use the software to create and test their algorithms. The software will automatically enter and exit trades based on the trader’s parameters.
The second step is to choose a broker. Not all brokers offer algorithmic trading. Ensure to do your research first. Once you have found a broker that offers this service, you need to open an account. When you open a regular trading account, some paperwork needs to be completed and transferred. The minimum deposit for algorithmic accounts can vary from broker to broker, but it is usually between $500 and $20,000, depending on the fees of their respective platforms.
The next step is choosing the assets you want to trade. The available assets will vary depending on your broker but usually include stocks, futures, options, and ETFs. As a beginner, when using algorithmic trading, you will need to decide what type of order you would like to use. Once the orders are placed, the software will take care of the rest.
Types of Algorithmic Trading strategies
There are several different types of algorithmic trading strategies that you can use. These include:
1. Arbitrage Strategies
This strategy aims to capture the moment when prices become misaligned.
2. Mean Reversion Strategy
This strategy predicts that a low will be followed by a high and vice versa. There must be enough historical data available to smooth out market fluctuations for it to work.
3. Trend Following Strategy
This strategy attempts to capitalize on the trend of the market. It does this by buying assets when they increase and selling them when they decrease.
4. Pairs Trading Strategy
This strategy takes advantage of price discrepancies between two different assets. For example, if you think that Nike stock will outperform Adidas stock, you would buy Nike stock and sell Adidas stock. If the prices move in the opposite direction than expected, you will close the trade out at a loss.
5. Market Timing Strategies
These strategies attempt to take advantage of market timing. They are constantly monitoring the markets and will only open trades when advantageous for them to do so.
6. Contrarian Strategies
These strategies operate on the belief that large groups of traders are usually wrong. You can make money when everyone else loses it by taking the opposite side of these large trades.
7. Scalping Strategies
This strategy attempts to capitalize on minor price differences between assets or exchanges by buying and selling quickly.
Benefits of Using Algorithmic Trading Strategies
1. Increased Liquidity
Algorithmic traders can execute trades more quickly than humans, increasing liquidity and making it easier for other market participants to buy or sell assets.
2. Reduced Risk
Algorithmic trading strategies rely on mathematical models, so they are less likely to be affected by human emotions such as fear and greed. It reduces the chances of making irrational decisions under pressure.
3. High Accuracy
Most algorithmic trading strategies generate orders based on historical data alone, so there is no need for complicated financial analysis that may not be accurate in real-time.
4. Low Cost
Most algorithms use a set of pre-determined rules that do not require any manual intervention from developers, resulting in lower fees compared with discretionary strategies.
Disadvantages Associated with Algorithmic Trading
1. Increased Complexity
Algorithmic trading strategies can be quite complex and require extensive testing and tweaking before being used.
2. High Latency
The time it takes to reach the exchange can significantly impact profitability. Some algorithms are designed to trade only when there is a tiny difference between the bid and offer prices, so any delay in execution could result in missed opportunities.
3. Susceptibility to Hacking
Algorithmic traders are often reliant on sophisticated computer programs and code, making them vulnerable to hacking attacks. If these systems are compromised, it could lead to significant losses for the trader.
In summary, algorithmic trading is a process that uses computers to enter and exit trades automatically. There are several different algorithmic trading strategies, each with benefits and risks. Before using an algorithmic trading strategy, research and understand the risks involved. It is important to remember that algorithmic trading requires a significant amount of capital and experience to be successful.