The concept of algorithmic trading is fairly new in India. Simply speaking this type of trading makes use of a software or computer program to place a trade following an algorithm. An algorithm consists of a pre-defined set of instructions that is already available within the algorithmic trading software.
To simplify the concept of algorithmic trading further, let us take an example. Suppose the trading software is given two instructions:
- When the moving average for 50-day of a stock option crosses the 200-day mark, buy 50 shares of the same and
- When the moving average for 50-day goes below the 200-day mark, sell the shares.
The software automatically starts to monitor the prices of the said stock. It buys the shares and sells them when the given criteria are met. This frees the trader from having to monitor live stock prices and initiate manual order placement. The algorithmic trading system automatically does the same for the trader after accurately identifying a trading opportunity. It, however, requires an algorithmic trading platform to carry out the given instructions.
Advantages of algorithmic trading
The popularity that algo-trading has achieved in a short time is proof of its profitability. There are also several benefits attached to the same as:
- Being able to avail of the best possible price for making the trade,
- Quick and accurate order placement thereby increasing the chances of success,
- Accurate and instantaneous timing of the trades enable traders to avoid huge price fluctuations,
- Transaction costs get reduced significantly,
- Simultaneous checks for trading conditions can be automatically placed on multiple markets,
- Huge reduction in errors commonly occurring when placing manual trades,
- The availability of backtesting feature enables traders to check the viability of a strategy by using real-time and historical data to test its outcome before its implementation,
- Emotional and psychological influences and the mistakes resulting from them get completely obliterated.
This high-frequency trading thus makes an attempt to ensure profitability by making use of certain pre-programmed instructions to:
- Place a significantly large number of orders at a rapid pace,
- Across multiple markets based on multiple decision parameters.
Uses of algo-trading
Algo-trading finds its use in several different forms of investment-making and trading activities like:
- Buy-side firms or mid to long term traders like those involved in pension funds, insurance sector, mutual funds etc., make use of custom-built algorithmic trading software to purchase stocks in huge quantities by making large volume investments discreetly. This enables them to complete the activity without influencing stock prices.
- Sell-side participants, typically short term traders, include the market makers or brokerage houses, the arbitrageurs, the speculators etc. They benefit enormously from the option of automated trade execution that algo-trading provides. Algo-trading aids help create market liquidity thereby making it profitable for the sellers.
- Systematic traders are generally trend followers like those involved in hedge funds or pair trading. They make use of the algorithmic trading platform to input the required trading rules and let the software keep trading automatically.
Algo-trading is a very interesting phenomenon. The deeper one goes into it the better one understands its benefits. The systematic approach that is followed makes active trading much more practical than when using intuitive or instinctive predictions.