Algorithmic trading, AKA algo trading, employs high speed computer programs and predetermined criteria to trade. This manner of trading gets into and out of the market at high speeds. A simple example of algo trading is when the program is set to purchase a stock very quickly when it falls below a set price and to sell it again when it rises to another set price. The value of algo trading is that the program watches the market, does not fall victim to fear or greed, and executes trades quickly before opportunities disappear. But, does algo trading work for the average trader?
Types of Algo Trading
There are as many types of algo trading as there are ways to day trade. The most common types are momentum investing, mean reversion, factor-based investing, ETF rotation strategies, smart beta, trend following, sentiment analysis, statistical arbitrage, and seasonality strategies. Just like regular day trading, you can employ algo strategies that are pretty basic or ones that are increasingly complex. The advantage of algo trading programs is that they can do the analysis needed to successfully employ complex approaches a lot faster than you can. This lets you get into and out of a lucrative trade while the possibility exists and not miss out because you had not finished your calculations!
FX Algo Trading Strategies
Algo trading is not limited to the stock market. The biggest market in the work by daily dollar volume is the Forex market where traders typically employ a high degree of leverage in order to profit from small changes within currency pairs. FX algo trading strategies are generally similar to those used for trading stocks. Investopedia has a nice discussion of Forex algorithmic trading. The advantage of being able to make fast trades at high volume can turn to a disadvantage in an extremely volatile market or when a flaw in your algo program results in repeated losses!
Algo Trading Risk Management
On a basic retail investor level, risk management for algo trading involves the use of understandable and reliable programs that duplicate what you would do in a trade but do it faster and without letting emotion take hold. Even basic programs need to be evaluated routinely to make certain that they are doing what you want and actually making money on your behalf. The more complicated algo programs are, the more prone they are to problems and thus need competent oversight. Deloitte has a useful (and lengthy) discussion about when algorithms go wrong.
Algo Trading Performance
The goal of algorithmic trading is to make to take a successful trading strategy that makes money on most trades and simply make more trades. This means you will make more money with expected algo trading performance. Although this is a laudable goal, you need to keep track of your algo trading performance on a daily basis. So long as the program is making money many traders simply leave it along. However, there are times when the program may not make you any more money than when you handled each and every trade in person. When that is happening your choices are to dump algo trading and go back to the old way or tweak your program so that it does what you want!
Algo Trading Signal
An algo trading signal is the same as a signal that you would look for sitting at your trade station. But, it needs to be coded into a computer program in order for it to work. The advantage of a good algo program is that it sees signals that you might miss, sees more signals, and sees them quicker. An algo program can also be working when you are absent. Basic programs can wait to buy when a stock prices fall to a given level and proceed to follow your programmed instructions to set stop losses and to execute trades that not only make money but also reduce your risk of loss.
Open Source Algo Trading Software
One of the concerns about getting into algo trading is that you will need fast and sophisticated programs, computers, and internet access to take advantage of the most fleeting opportunities. These programs can be very expensive and costly to maintain. Luckily, there is open source algo trading software. The retail trader is not looking to compete with the fastest programs but rather to take advantage of trades that occur throughout the trading day and to do so without fault and without fail. If you have the technical competence or have access to a programmer who will not break your budget, an open source program may be your best bet.
Fixed Income Algo Trading
As the use of algo trading programs has expanded, asset classes other than stocks or currencies can be traded using this approach. As with algo stock trading, parameters can be set up to purchase at the best prices such as when interest rates fluctuate upwards and bond prices fall. Likewise, the same bonds can be sold using an algorithmic program that sees a drop in interest rates and a concurrent increase in the value of the bonds. As with any algo program, you will want to track performance to make sure that the criteria that you have set up are producing the profits that you expected.
Does Algo Trading Work? – Slideshare Version