What is Algorithmic Trading?

No matter your degree of trading expertise, it is always good to keep yourself informed about the latest trading tools and how they can be used to improve your trading strategy. 

Algorithmic trading is one of many tools used in trading. We aim to give you a crash course in algorithmic trading and answer some of your burning questions.

We answer the question ‘what is algorithmic trading?’, discuss how it works and we go over its pros and cons. We also discuss its uses and technical requirements.

It's not a trading tool that we’d recommend to beginners but is a good trading tool to increase your capital. Public Finance International is here with the nitty gritty details:

What is algorithmic trading? 

Algorithmic trading, also known as automated trading or algo-trading, is an automated trading program. It uses a computer program that follows a specific algorithm to execute trades on behalf of traders. 

This trading instrument is used because it is thought to be able to execute trades at an inhuman frequency, speed, and volume, thus increasing profits. 

The algorithm that the program follows is a clearly defined set of instructions that outlines factors like timing, quantity, and price. 

Algorithmic trading plays a role in increasing the liquidity of market exchanges. 

Traders can control the algorithm by setting parameters regarding factors like price fluctuations and volatility levels. These parameters are then used by the algorithm in conjunction with computer codes and chart analysis to execute trades. 

Algo-trading is commonly used in high-frequency trading (HFT). HFT aims to generate profits by placing a high volume of orders and increased speeds, across multiple markets and based on multiple decision parameters. 

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How does algorithmic trading work? 

Algorithmic trading works by following two simple criteria: 

  • The first is to buy, for example, 50 shares of a stock once its 50-day moving average becomes higher than the 200-day average.
  • The second is to sell shares of a stock once its 50-day moving average drops below the 200-day moving average. 

With these two instructions, the algorithm can automatically monitor the stock price as well as the moving average indicators. Based on these instructions, it will then place buy and sell orders once the criteria are met. 

This means that traders are no longer required to closely monitor the live data feeds and charts. The algorithm will automatically monitor these factors and execute trades on behalf of the trader. 

The pros and cons of algorithmic trading

Here are the pros and cons of algorithmic trading:

Pros:

  • Algorithmic trading removes human error.
    Trades are executed based on a computer program and follow a specific set of criteria. Therefore, it negates the need for human intervention and eliminates human error. 
  • Allows backtesting.
    Traders can backtest and refine the algorithm in conjunction with historical data. This allows traders to determine the best combination of parameters to follow when executing trades. 
  • Low maintenance.
    Since the algorithm tracks market trends and price point movements, as well as executes trades on behalf of the trader, there is very little need for the trader to actively manage their investment portfolio. Algorithmic trading is a great option if you want a hands-off approach to trading. 
  • Increased opportunity to generate capital.
    Traders can customize the algorithm according to their trading strategy, as well as make changes later on to suit their needs, wants, and financial goals. This freedom lets traders maximize their exposure to opportunities in the market. 

Cons:

  • Traders are required to know the programming process.
    Algorithm trading requires traders to develop the algorithm to fit their trading strategy. This requires technical knowledge about programming, a skill that not all traders have. Traders will either have to learn the skill or hire a professional to do it for them. 
  • Loss of human control.
    The lack of need for human interaction is both a pro and a con. Algo-trading is a completely automated trading process. So, while it is great to have a hands-off approach to trading this also means that you give up a measure of control. For example, if you realize that you’d rather not execute a certain trade, you would be unable to stop it from happening. 
  • Algorithms generally have short life spans.
    The life span of most algorithms is very short and often rapidly shut down. When this happens, traders are required to either fix the algorithm or recreate an algorithm that can keep up with current market trends. This process is a continuous cycle of recreating, fixing, and optimizing algorithms to suit the needs of the trader, and current market changes. 
  • Algorithmic trading is completely dependent on technology.
    The algorithm and trade orders exist on computers and not on an online server. Therefore, if the internet connection is lost or the computer crashes the trades will not be executed. This can cause traders to lose out on great trade opportunities and lose money as well. 

The technical requirements of algorithmic trading

Before you decide to use algorithmic trading, there are quite a few technical requirements that are needed. These factors are needed for the algorithm to optimally function.

  • Traders who wish to make use of algorithmic trading require the technical know-how needed to program the algorithm and set the proper parameters.
  • Traders also need a stable internet connection to connect the algorithm to the market exchange and allow it to execute trades. Due to the algorithms dependent on technology, the internet connection must be secure to avoid issues like the loss of the internet connection.
  • The algorithm also requires access to market data feeds. The algorithm will monitor data feeds and use the information to make trade decisions based on the parameters the trader has set.
  • A relatively powerful computer. This is another vital requirement of algorithmic trading. Without a computer with sufficient specs, the algorithm won’t be able to function optimally. A weaker computer might be prone to crashes and this could affect the performance of the algorithm. 

In Summary

Algorithmic trading is a great tool for traders who would like a more hands-off approach to trading. Essentially, algo-trading is a computer program that executes trades on behalf of the trader based on parameters set by the trader. Algo-trading also bases trades off live market data feeds. 

Traders can customize the algorithm to suit their needs, wants, and goals, as well as their trading strategies. 

Algo-trading does not require any human intervention and is very low maintenance. This makes algo-trading a good option for traders who have busy lifestyles and are unable to commit much time to trading. 

A downside to this tool is that it has a very short life span and traders are required to constantly fix or recreate the algorithm according to changes in the market exchange. 

We wouldn’t recommend this tool to beginners with limited knowledge concerning trading and computer programming, however, this tool could be a great way to increase your capital.