Algorithmic trading (also known as automated or algo trading) is a method of trading where an individual uses a computer program (an algorithm) that has predefined rules and instructions to place a trade on an exchange. These predefined rules can be based on timing, price, quantity, action or any mathematical model. A trader or strategy developer will create a trading algorithm with specific trade rules and then the owner will deploy this algorithm for it then to execute trades automatically on the traders behalf.
As a derivative of technical analysis, algorithmic trading takes trading positions based on pure mathematics and data. Algorithmic trading is also a part of quantitative finance, the opposite of value investing where trading decisions are made based on fundamentals.
In comparison to methods based on trader intuition and instinct, algorithmic trading provides a systematic and software-driven approach to trading. Though algorithmic trading is a derivative of technical analysis, technical analysis often aids humans to take trading positions, whereas trading algorithms follow a set of trading rules that independently executes trades on the market 24/7
Traders have the ability to customise their trading algorithm by choosing several different strategy types, for example, directional strategies that anticipate market movement based on trends, mean reversion, market neutral strategies where the algorithm seeks to make a risk-free profit over arbitration and dislocations over different markets.
Benefits of algorithmic trading
- Allows you to work with multiple trading pairs and assets simultaneously.
- Removes the emotional and psychological attributes of trading by having the algorithm place trades rather than the human.
- Simultaneous automated checks on multiple market conditions.
- The ability to trade 24/7 and still carry on with your day-to-day activities, manual trading is limited by human maintenance (eating & sleeping).
- Trading algorithms can be easily backtested using historical data to see if the strategy operates as intended.
- Instant analysis of indicators, charts and volumes.
- The risk of manual errors is reduced when placing trades, this avoids any issues caused by mistyping buy or sell orders.
- Instant reaction to price fluctuations and traders can execute trades as soon as they happen.
- Trading algorithms will automatically make trades leaving the machine to do all of the work, this means traders can handle much more manual trades at the same time.
Limitations of algorithmic trading
- Dependent on technology. Trades could be missed due to having a system that is unreliable or slow to place trades.
- Many trading algorithms require technical knowledge to build.
- Intuition trading is removed, which may be a positive edge for some experienced traders.
- If the strategy was chosen incorrectly or there were mistakes in setting up, the algorithm will not stop performing trades, even if they lead to losses.
- Basic trading algorithms cannot perform fundamental analysis and react to market news.
- An algorithm cannot opt to pass a trade, even if it is based on a false signal, for example a false breakout. This is unless it is a very sophisticated algorithm.
- Trading algorithms tend to have limited life spans, or may work only in certain market conditions, and need to be monitored for performance.
How do I create a trading algorithm?
Algorithmic trading relies on quantitative analysis and financial market knowledge. To first begin this process you will need to have an adequate level of knowledge in this field. Secondly, as trading algorithms rely on technology and computers, you will also need to have a technical understanding of coding or programming.
Once you have these prerequisites you can begin building out your trading algorithm along with backtesting to see how your algorithm would perform using historical data and analyse if your algorithm is performing as intended. We have published documentation and tutorials on how to create a trading strategy here.
There are also ways for traders to leverage trading algorithms without needing technical knowledge of both the market and coding. Traders can use protocols such as Trading Strategy, to find trading algorithms created by strategy developers and quantitative finance experts to invest in strategies directly. This allows them to bypass the technical knowhow and benefit from algorithmic trading and trading strategies created by experts.
The bottom line
Algorithmic trading utilises modern technology and software to create an automated process of traditional methods. Traders are able to leverage trading algorithms to quickly action trade orders when they are away from their device and with many options available in today’s landscape, algorithmic trading is prevalent in financial markets. Coupled with cryptocurrency’s 24/7 open market, algorithmic trading can enable traders to create a comprehensive trading strategy to fully capitalise on the modern and more efficient markets available today.
About Trading Strategy
Trading Strategy is an algorithmic trading protocol for decentralised markets, enabling automated trading directly on blockchains. Learn more about Trading Strategy in the introduction post.
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