Algorithmic trading software can help you place orders more efficiently and within specific parameters. This guide to algo trading outlines what this software does, its relevance in the financial sector, and some algorithmic trading strategies you can try.
This article at a glance:
- Algo trading uses coded instructions to execute buy or sell orders.
- It is automated, objective, instant, and monitors every market move at scale.
- A large amount of trading volume comes from algo trading.
What is algorithmic trading or ‘algo-trading’?
Algorithmic trading, also known as algo trading, is a trading method where the trader uses software to buy and sell financial instruments such as forex. Here, traders set predefined instructions for the software to follow. Whenever markets meet these conditions, an order is executed accordingly.
These conditions focus on specific market variables, such as price, and determine when trades are opened and closed. For example, traders may set the instruction to sell an asset when the Relative Strength Index (RSI) indicator goes above 70, and buy it back when it drops below 30.
The software will then operate according to this coded instruction, and execute the orders.
Algo trading is automated and objective. It removes the need to constantly monitor markets, and also eliminates subjective or emotion-based trading. Further, because everything is handled automatically, you can spend your time doing more market research and technical analysis, or test out new trading strategies.
Largely used by institutional traders and market makers, algo trading can also be used in some ways by retail traders (depending on their trading platform).
How much trading is done by algorithms?
Wall Street data shows that algo trading accounts for between 60% and 73% of US equity trading activity. Why are so many traders using algorithmic trading software? Speed and efficiency are important reasons.
Following minute-by-minute changes in the markets can be tedious, time-consuming and expensive. Algorithmic trading software solves these issues, and can also open/close trades almost instantly, helping capture even the most rapidly moving opportunities.
Moreover, algo trading helps remove the emotion from trading. It doesn’t get upset if a trade goes wrong, nor does it get excited if things go well. Unlike for individuals, whose judgement may be clouded by these emotions, algorithms remove emotional bias from trading.
Benefits of using trading algorithms
Here are some of the potential benefits of algo trading:
Algorithm trading reduces the risk of human error – automated trading helps execute orders exactly when trading instructions are met, helping lower the risk of human error.
Algo trading stops you from acting emotionally – the algorithm isn’t affected by emotional swings that may impact its objectivity when making trading decisions.
Automated trading is fast and efficient – the software monitors every single market movement at scale, and also executes orders instantly.
Algorithm trading can be tested – you can test your algorithmic trading strategies using historical price data to see how well your strategies work.
Popular algorithmic trading strategies
There are various algorithmic trading strategies you can use, and some of the most popular are:
This strategy sets trading instructions based on technical indicators, such as moving averages and breakouts. The goal is to make moves based on market trends.
Arbitrage is the act of simultaneously buying and selling the same asset on two different markets. The price difference is the trader’s profit or loss.
Index fund rebalancing
Index funds routinely adjust their holdings to match values reflected by indices. Trading algorithms can be used to make moves quickly within this brief readjustment period.
Algorithms can be set to buy or sell if prices move above or beyond a certain level. This is particularly useful in executing a large number of orders.
Algorithm trading is not a sure-fire way to make money. It is, however, a practical tool for automated trading that maximises the efficiency of your strategies. Used with appropriate risk management measures, it can make for a useful addition to your overall trading strategy.
This material is for general information purposes only and is not intended as (and should not be considered to be) financial, investment or other advice on which reliance should be placed. INFINOX is not authorised to provide investment advice. No opinion given in the material constitutes a recommendation by INFINOX or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.