What Is Algo Trading?
Algorithmic trading, popularly known as Algo trading, is basically a process of executing orders that use automated and pre-programmed trading instructions, accounting for variables like time, price, and volume. These trading instructions are basically based on a set of rules born out of historical data analysis and statistical results, which makes it possible for traders to execute an order at frequencies and speeds impossible for any human trader.
Algorithmic trading combines complex mathematical models of security markets with high-speed and high-frequency trading systems. The algorithms keep tracking the markets continuously and execute trades in fractions of seconds at the most opportune moments so that gains can be netted from market inefficiencies and price discrepancies.
Some primary advantages of algo trading include keeping human emotions out of the way in trading decisions. This framework will reduce the errors of a trader due to psychological biases and result in more disciplined and consistent trading. Besides this, algo trading results in much faster processing or analyses of large reams of market data compared to a human, hence making more informed and timely decisions..
Algo trading has been applied to equities, foreign exchange, commodities, and fixed-income securities—due to its efficiency, cost-effectiveness, high-frequency generation with precision, and various other features.
The risks, however, are not nil in algorithmic trading. First of all, there is dependence on technology; any technical failure or flaws in the algorithm can cause huge losses. Moreover, high-frequency algo trading may add to market volatility. It may even cause flash crashes, meaning that the market suffers from a sudden steep drop in prices within a very short period.
How To Build An Algo Trading System?
So, the first step to keep in mind is to define your requirements. People often think that they are free to go by just creating an Algo System and that they can start earning right away.
You have to understand that in any case, you have to first create your strategy and you should have that strategy in place before you even start working on the Algo System. The lack of a specific strategy becomes people’s biggest issue. They may have a lot of ideas in their head but they are unable to conclude a specific strategy to a set of rules and keep jumping from one strategy to another like a kangaroo.
- So you have to define first, and that’s the first step.
- The second step is to put it down on the paper. The majority of people stop right here and don’t document their strategy. On paper, it is meant to say that you should document it whether it is on Word Doc or Excel Sheet.
Every aspect of it, whether it is the entry, exit, trailing target, position, size, etc. The benefit of this step is when you are creating your algo there will be no confusion or missing points. All the dots will connect. This is why you need to write it down somewhere. - The Third step is programming but nowadays algorithms are made with Matlab, Python, C++, Java, and Pearl and based on these platforms, algo systems are made. Not everyone knows how to program but nowadays there are a lot of freelancers available to whom you can assign them tasks and get the work done.
- The Fourth step that a lot of people miss out on is to find out an accurate data one need the correct data sets and databases to produce accurate results. When you go to the internet for free data, it’s often non-credible and inaccurate. It’s important to take data from reliable sources when it comes to historic performance. Although you can get access to paid databases, it is suggested to buy the data from a reliable data vendor if you’re an intra-day trader. And you can get tips regarding this from people who are already running their algos by purchasing data. They will be able to guide from whom to buy data and who to avoid.
- The Fifth step finally is backtesting. If you check 8-10 years of backtesting while entering rough parameters that no matter what situation may arise for change in volatility, change in spread, etc. After applying all these things this increases the conviction of a trader. Backtesting’s purpose is not to show that a trader can never be wrong but it is rather to increase your confidence in your setup. This is important for you to understand either you can check the data manually, which will take a huge amount of time obviously, or you can hire a developer and let him make your entire setup.
Next, deploying at least 3 strategies it is important to understand. If you make only one strategy and then you backtest it only on one asset class or stock and use that only. Let’s take an example. Let’s take stock that we never talk about ITC. Now the biggest issue we can face with this in the future is a lack of liquidity, operators not participating, or lack of participants, or this stock itself stops working. Your strategy will be stranded and become useless in such a situation.
It is important and one needs to understand it whether you want to make a diversified portfolio, a strategy that you can test on multiple assets. And along with it’s better for you to make 2-3 strategies so that your winning streak isn’t hampered in the long run.
You should remember one more thing, whatever stocks or indices you have bought, whether you’re taking ATM or in the money option, keep reviewing them. Whether news flow is increasing in your chosen stock and if there’s any change in the momentum, whether the traditional move is changing, whether those participants are still doing the same thing. This will increase your conviction and will help you filter out any stock you want.
