Every trader has their own preferred way of trading the markets, but algorithmic strategies have the potential to help with them all. Also known as black-box or automated trading, algorithmic strategies involve the use of technology to respond to market conditions far more quickly than a human could. Automated or algorithmic trading colloquially refers to the automatic trading of securities by computer programs on a stock exchange.
The idea of relinquishing control to a computer program or algorithm might sound terrifying. But in practice, you’ll always remain in control. In automated trading, exchanges report a share of up to 50 percent of exchange turnover. Below, we look at how algorithmic strategies work in practice and how they could help with trading.
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Benefits of Algorithmic Trading
Automated trading is used by hedge funds, pension funds, mutual funds, banks and other institutional investors to automatically generate and/or execute orders. Here, computers independently generate buy and sell signals that are converted into orders in the financial center before humans can even intervene. Algorithmic trading can be used with any investment strategy: market making, inter-market spreading, arbitrage, trend following models or speculation. The concrete application of computer models in investment decisions and implementation is different. Thus, computers can either only be used to support investment analysis or the orders can be generated automatically as well as forwarded to the financial centers. The difficulty with algorithmic trading lies in the aggregation and analysis of historical market data, as well as the aggregation of real-time prices to enable trading. Similarly, setting up and testing mathematical models is not trivial. If you have been reticent about using algorithmic trading, here are some of the advantages you could enjoy:
- All trades will be executed at the optimum price
- Execution is instant and accurate
- Lower transaction costs
- No chance of manual errors
- Algorithms can track multiple market factors in real-time simultaneously
- No influence from emotional factors
- Strategy can be back-tested using historical data
Algorithmic trading offers the greatest benefits for high-frequency trades, enabling multiple trades to be executed rapidly across numerous markets. For example, if you were interested in indices trading on SP and FTSE, you wouldn’t need to jump between the two. The algorithm could monitor both on your behalf, executing trades in line with your instructions.
But this doesn’t mean that algorithms are only used by scalpers; they can be useful in other scenarios, too, such as in large purchases, spotting trends and to avoid policy arbitrage.
Mid-long term investors might want to purchase a large volume of shares but are concerned about the potential effect on the share price. Insurance companies, mutual funds and pension firms would be examples of this.
To avoid an artificial impact on the share price, a common tactic is to buy small batches slowly, spacing out each purchase and checking for a market response after each one. This can incur extra costs and, for substantial quantities, may take days to complete. An algorithm can speed up this process by checking for any impact on the share price after each purchase and altering the rate of future purchases. This can save time and a lot of manual effort and spot micro-changes in the share price more quickly.
Algorithms are the best suited to spotting trends and patterns as this doesn’t require any sophisticated predictions or pricing forecasts. Using an algorithm means it’s possible to spot a trend more quickly, opening up opportunities to capitalise more effectively.
The trends that an algorithm might be used for are broad and diverse. Examples include moving averages, price level movements and channel breakouts. Trades can be executed based on when desired trends are identified, an easy strategy to program and implement, even for algorithmic beginners.
A dual-listed stock offers opportunities to cash in on the price differences, but you’ll need to take advantage quickly. An algorithmic trading programme is ideal for this, enabling you to buy and sell almost simultaneously, benefiting from the price difference. The two prices may only have a minimal difference, but this can deliver substantial returns when trades are executed at high volumes.
High Frequency Trading Vs Systematic Trading
In the literature, algorithmic trading is often equated with high-frequency trading, in which securities are sold and sold again in fractions of a second. However, fund managers categorize the field of algorithmic trading very differently. For example, over 60% of respondents understand high-frequency trading to mean transactions in the period from 1 s to 10 minutes. Approximately 15% of respondents understand this to mean transactions in the period of 1-5 days. Computer programs are not only used in the short term, but can also trade independently in the long term in the course of several minutes, hours or days.