What is Algorithm Trading, and How Does It Work?

Nowadays, human life relies entirely on AI (artificial intelligence) technology. According to research by Georgia University, humans trust computers more than other humans. Advancements in technologies changed the way of doing things, and they also changed the way of trading. However, algorithm trading is also a result of this advanced technology, which has become a tremendously popular trading method.

Algorithm trading is also referred to as automated trading or black box trading. This trading method is done by using a computer program, and that computer program follows the algorithm. The algorithm is a set of step-by-step instructions for solving the desired problem. Algorithm trading can produce massive profits at a much faster speed than in manual trading.

Algorithmic Trading Bots

Basics of Algorithm Trading

Algorithm trading combines advanced computer programming and stock markets to execute the trades. The main goal of the algorithm trading method is to strip out the emotions humans face while buying and selling stocks. Stripping emotions ensures the instant and efficient buying and selling of financial assets.

Algorithm trading uses software to create different algorithms for trading purposes. After executing the algorithm computer will make a specific trade. This trading method mainly uses a technology named HFT (High-Frequency Trading). This HFT technology allows the computer system to generate thousands of stock deals per second.

How to Start Algo Trading?

To start algorithm trading, you need access to a high-end computer system and knowledge of the stock market. However, before starting the algorithm trading, you must fulfil other requirements.

  • Algo trading completely works on the programming, so you need to master any one programming language. If you want to avoid learning to code, you can hire an expert programmer or buy Algo trading software.
  • Strong network connectivity and access to some trading platforms for buying and selling stocks.
  • Complete access to recent years' stock marketing data.
  • Access to the past stock data to back-test your trading algorithm.

Advantages of Algorithm Trading

Algorithm trading has many perks compared to manual human trading methods. These perks allow stock traders to generate massive profits in much less time than traditional trading methods.

  • Trades are bought and sold at the finest possible prices according to the market.
  • Orders of trades are placed very instantly and accurately.
  • The trades are precisely timed, and the exact time avoids price changes.
  • Transaction costs applied in Algo trading are much less than in manual trading.
  • Regular checks on the stock market trends.
  • Algo trading decreases the risks of human errors while placing orders for trades.
  • Algorithms used while trading on stocks can be back-tested before being used on real-time stocks.

Practising Algorithm Trading

While practising algorithm trading, an investor can follow up on these two ideas:

  • You can buy 50 shares when the moving average of 50 goes above the moving average of 200. A moving average can be referred to as the average of fluctuations of past-day data points.
  • Then you need to sell these shares when the moving average of 50 goes below the moving average of 200.

When you give these two instructions in the computer program, the trading algorithm will automatically monitor the stock price and platform to buy or sell the stock where the above two conditions are met. With algorithm trading, now investors don't need to check the prices and graphs of the stocks manually regularly.

Is the Method of Algorithm Trading Legal?

The question that arises in most people's minds is whether practising algorithm trading is legal. Algorithm trading is legal in most parts of the world, but some countries prohibit the algorithm trading method.

Some deals in black box training involve the insider training method. Sometimes the algorithm delivers those trading signals which might alert others. However, because the algorithms deliver the information beforehand, it might influence the market incorrectly. Therefore, sometimes these algorithms are marked as illegal by the stock market. Otherwise, all the other trading algorithms are legal.

Different Algorithms Used in Trading Strategies

Strategies in used algorithm trading aim to increase trading revenues and cut down transaction costs. However, the most popular algorithms in trading strategies are mean reversion, market timing, and index fund balancing.

Mean Reversion

Mean reversion uses a mathematical method in trading stocks. First, it calculates the mean of the stock's high and low prices. This technique involves calculating the range and average price of a stock. When a situation occurs, the current market price is lower than the stock's average price. In this situation, the stock is called an attractive stock.

Market Timing

The market timing algorithm includes three stages of testing – back-testing, live testing and forward testing. Backtesting is the first stage in this process, where the algorithm is tested on the historical stock data. It produces hypothetical results.

Then, the next stage is of performing the optimization, where the most optimal results are fetched. This is the stage of forward testing which involves testing the algorithm within the data back-tested data. The last stage of testing is live testing, and it requires a programmer where he compares the live result with the previous two stages.

Rebalancing of Index Funds

The index funds like pension or retirement funds are consistently adjusted according to the market assets. This adjustment of funds is also known as the rebalancing of funds. Moreover, this rebalancing of funds creates many profit opportunities for traders who mainly trade index funds. An advanced algorithm trading system performs these trades.

Arbitrage Practice

Arbitrage is where traders take advantage of the occasional small trends in two different markets. For instance, a trader buys a stock at a lower rate from market A and sells that stock in market B at a premium rate.

For arbitrage practice, you need to meet the three conditions. First, you should not trade the same stocks at the same price in all the markets. Secondly, the stock with the same amount of cash flow must not be traded at the exact price. Then, a stock whose future price is known should be traded at that same price today.