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Algorithmic Trading: How It Works and Its Role in Modern Markets
Trading
Iva Kalatozishvili
Business Development Manager
Demetris Makrides
Senior Business Development Manager
Algorithmic trading is a trading method that requires the usage of certain programs and algorithms that automate the processes of opening and closing positions. High-level traders do not handle all the processes manually, but set orders with the help of robots.
Key takeaways:
- What is algorithmic trading?
- How does algorithmic trading work?
- What are the benefits and limitations of algorithmic trading?
- What are the best strategies of algorithmic trading?
- How to choose the right strategy when using algorithmic trading?
What Does Algorithmic Trading Mean?
In the era of digital technologies trading cannot step aside from innovations. Algorithmic trading that combines mathematical models and automation processes, is the bright example of symbioses between traditional financial markets and the latest technologies that revolutionize all the spheres.
Under the term “algorithmic trading” one should understand the trading process automation with the help of algorithms that analyze market information and decide which time is the best one to open/close a position.
Such algorithms take numerous criteria into account (for instance, an asset’s price, trading volumes, historical data, and so on) which means those are much more precise than a human trading. Algorithmic trading is compatible with both basic and complicated strategies. Furthermore, such a process can be significantly improved by the latest technologies (AI, machine learning).
On the other hand, algorithmic trading has one more meaning. Under this term, traders may understand the process of dividing one big order into smaller pieces. As such, orders are executed much more quickly and protect a trader from the price fluctuations.
How Does Algorithmic Trading Work?
What are the working principles of algorithmic trading? Let’s imagine that a professional trader has a strategy according to which he opens and closes his positions. The strategy is based upon several tech indicators (e.g., the combination of moving averages, oscillators, strength indexes, etc.). What should a trader do next?
- A trader uses a trading robot applying all the required settings. From this moment, the bot begins to analyze the market independently, determines the best moments to enter the market and close trades.
- A trader does not waste time on opening and closing orders, the entire process is automated. The trader only needs to monitor the results and manage the balance allocated for trading.
Here is why, algorithmic trading is the best choice for professional traders as they are able to improve their results significantly.
The Major Types of Algorithmic Trading Bots
Up-to-date trading platforms can provide their clients with the following types of algorithmic trading advisers:
- Traditional advisors. The trader sets all the necessary settings, adapting the bot to his strategy. Risk management principles and the maximum volumes of each transaction are also taken into account. In other words, traders just automate their manual orders to get the opportunity of opening hundreds of positions within short periods of time.
- Advisers equipped with innovative technologies. Such advisors are equipped with neural networks, AI-algorithms, and machine learning principles. Here is why such advisors are able to analyze the markets on their own, compare financial data, and evaluate the current market situations. Those advisors do not just automate trading processes but are able to improve a trader’s skills and make the trading process more efficient.
When talking about the second type of algorithms, those are frequently used by institutional investors who are involved in the High Frequency Trading style. Traditional advisors are always useful no matter which markets and trading situations take place.
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The Benefits and Limitations of Algorithmic Trading
When talking about the key benefits for traders, the following advantages are primarily taken into account:
- Reaction speed. Robots are definitely much quicker than human traders; which is why bots are much more effective when talking about scalping and HFT trading styles.
- Automation of trading processes. A trader is able to apply algorithms for different assets simultaneously. Robots can control 10+ positions on 10+ charts; which is impossible for a human trader.
- Lower load on a trader. Robots exclude the possibility of emotional traders and uncontrolled spontaneous positions. All the orders are opened in the strict correspondence with the chosen strategy.
- Diversification of risks. Traders do not need to use one and the same advisors. Professional traders test different robots to get the best results.
As for the limitations, algorithmic trading is characterized by the following cons:
- Robots do not take into account fundamental factors. For instance, a bot opens positions according to a certain strategy; meanwhile, the sudden fundamental news may sharply change the behavior of market players.
- Robots do not pay attention to major players. Market makers are able to shift an asset price with the help of giant orders. Robots cannot predict such situations. Furthermore, robots are useless against spoofing – when market players place orders and then delete them.
- The efficiency of robots is low within the market fluctuations. High volatility is a true enemy of algorithmic trading; which is why robots are less effective when talking about cryptocurrencies and exotic trading pairs.
- Algorithmic trading is not flexible enough. Traders are able to change volumes, number of positions, risk management principles, etc. Robots open positions according to their own settings.
- Technical issues. Finally, algorithms can become a victim of technical failures and errors.
The Top-3 Strategies that Are Frequently Combined with Algorithmic Trading
Algorithmic trading is frequently combined with the following strategies:
- Trend Following;
- Mean Reversion;
- Channeling.
Let’s dive deeper into the understanding of how to use algorithmic trading with the above mentioned strategies.
Trend Following
The main idea of the trend following strategy lies in identifying the current trend and its strength. When a strong trend takes place, the robot opens a number of positions according to the trend. The exact number of positions depends on trading volumes and risk management criteria.
Which tech indicators are used to identify whether the current trend is strong enough? Professional traders utilize the following tech indicators: Moving Averages, Parabolic SAR, RSI.
One should open long positions when:
- Parabolic SAR marks are under the candlesticks.
- RSI index is higher than 50.
- Moving averages (the short MA is above the long MA).
For instance, the robot analyzes the EUR/USD chart and finds out that the strong uptrend takes place. The program begins to open as many positions as possible limited by the allowed trading volumes and the chosen risk management strategy.
Professional traders cannot monitor the charts throughout the clock to find the best entry points. The trading bot is able to do so, opening new horizons for traders. When the robot finds confirmations that the trend is not so strong, it stops opening new positions.
Mean Reversion
The mean reversion strategy predicts that after an extreme price move an asset’s price will return to its normal levels. In most cases the strategy is oriented to corrections, but traders may be also looking for trend reversals.
When talking about tech indicators that help traders identify the signs of ongoing mean reversion SMA is the core one. The SMA line enables a trader to understand whether an asset’s price fluctuations are natural or it is going to come back to its average levels.
For instance, when a trader sees an asset’s price under the SMA line, he understands that it is going to return back. Meanwhile, trend reversals should be treated as exceptions.
Trading bots are able to analyze a set of different tech indicators and historical data to understand whether an asset’s price movement is trend reversal or its price will return to its medium levels. What’s more important, trading robots do everything necessary within milliseconds.
Channeling
Trading within a channel is one of the most popular strategies when talking about scalping or day trading. With the help of Bollinger Bands, Donchian Channel or other indicators traders identify the channel within which an asset’s price is moving. As such, one should open positions when the price touches the upper or lower border of the channel.
For instance, a trader activates Bollinger Bands to understand the borders of the channel. What should he do next?
- When an asset’s price touches the upper border of the channel, a trader should open a short position.
- When an asset’s price touches the lower border of the channel, a trader should open a long position.
Algorithmic trading is a perfect solution for channeling as the robot is able to monitor multiple charts in the 24/7 mode and open numerous positions based on the given criteria.
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How to Use Algorithmic Trading in Practice?
What should a trader do to activate algorithmic trading?
- Find out how algorithmic trading works.
- Choose the strategy you are going to combine with algorithmic trading.
- Select the trading platform and ensure that the platform is compatible with trading robots.
- Test the chosen strategy to understand how effective it is.
- Monitor the results, upgrade trading algorithms, and adapt your bots to the new market conditions.
Note! Do not treat algorithmic trading as the general solution to achieve success. No one can trade successfully without professionalism, experience, and correct understanding of the market.
The Bottom Line: Should a Trader Utilize Algorithmic Trading?
Algorithmic trading is a helping hand that is able to improve a trader’s results. Some strategies cannot be utilized without trading robots. Furthermore, the reaction speed is exceptionally important, especially on the volatile markets. Algorithmic trading makes it possible to earn on different markets and time frames simultaneously. On the other hand, algorithmic trading requires fluent skills, trading experience, and constant upgrade of your knowledge; otherwise, the automation processes will be easily transformed into losses.
FAQ
Theoretically, yes, they can; meanwhile, algorithmic trading requires enough skills and experience to understand market trends and choose the best suitable strategy.
Algorithmic trading is exceptionally effective and is able to improve a trader’s results; meanwhile, it comprises a number of “cons” as well. Under certain conditions, algorithmic trading may lead to heavy losses.
Yes, it is possible. Trading robots are claimed to improve the existing results and provide traders with opportunities they couldn’t access previously.
