Algorithm Trading Tips by Fred Smilek
Algorithmic trading (automated trading, black-box trading, or simply algo-trading) is the process of using computers programmed to follow a defined set of instructions for placing a trade in order to generate profits at a speed and frequency that is impossible for a human trader.
There are additional risks and challenges: for example, system failure risks, network connectivity errors, time-lags between trade orders and execution, and, most important of all, imperfect algorithms. (For more, see How to Code Your Own Algo Trading Robot.)
. These are the easiest and simplest strategies to implement through algorithmic trading because these strategies do not involve making any predictions or price forecasts. Such trades are initiated via algorithmic trading systems for timely execution and best prices. (For more, check out Picking the Right Algorithmic Trading Software.)
Using this set of two simple instructions, it is easy to write a computer program which will automatically monitor the stock price (and the moving average indicators) and place the buy and sell orders when the defined conditions are met. The algorithmic trading system automatically does it for him, by correctly identifying the trading opportunity. Cautious use and thorough testing of algo-trading can create profitable opportunities. Such detection through algorithms will help the market maker identify large order opportunities and enable him to benefit by filling the orders at a higher price. The trader no longer needs to keep a watch for live prices and graphs, or put in the orders manually. But one must make sure the system is thoroughly tested and required limits are set. Apart from profit opportunities for the trader, algo-trading makes markets more liquid and makes trading more systematic by ruling out emotional human impacts on trading activities.
There are a few special classes of algorithms that attempt to identify “happenings” on the other side. Remember, if you can place an algo-generated trade, so can the other market participants. Consequently, prices fluctuate in milli- and even microseconds. The more complex an algorithm, the more stringent backtesting is needed before it is put into action. (For more on high-frequency trading and fraudulent practices, see: If You Buy Stocks Online, You Are Involved in HFTs.)
Simple and easy! However, the practice of algorithmic trading is not that simple to maintain and execute. Analytical traders should consider learning programming and building systems on their own, to be confident about implementing the right strategies in foolproof manner. These “sniffing algorithms,” used, for example, by a sell side market maker have the in-built intelligence to identify the existence of any algorithms on the buy side of a large order. The related “steps strategy” sends orders at a user-defined percentage of market volumes and increases or decreases this participation rate when the stock price reaches user-defined levels. In the above example, what happens if your buy trade gets executed, but sell trade doesn’t as the sell prices change by the time your order hits the market? You will end up sitting with an open position, making your arbitrage strategy worthless.
Until the trade order is fully filled, this algorithm continues sending partial orders, according to the defined participation ratio and according to the volume traded in the markets. The above mentioned example of 50 and 200 day moving average is a popular trend following strategy. It’s exciting to go for automation aided by computers with a notion to make money effortlessly. This is sometimes identified as high-tech front-running. (For more on moving averages, see Simple Moving Averages Make Trends Stand Out.)
The greatest portion of present day algo-trading is high frequency trading (HFT), which attempts to capitalize on placing a large number of orders at very fast speeds across multiple markets and multiple decision parameters, based on pre-programmed instructions.
Quantitative analysis of an algorithm’s performance plays an important role and should be examined critically. (For more on high frequency trading, see Strategies and Secrets of High Frequency Trading (HFT) Firms.)
The most common algorithmic trading strategies follow trends in moving averages, channel breakouts, price level movements and related technical indicators. Trades are initiated based on the occurrence of desirable trends, which are easy and straightforward to implement through algorithms without getting into the complexity of predictive analysis. This creates profitable opportunities for algorithmic traders, who capitalize on expected trades that offer 20-80 basis points profits depending upon the number of stocks in the index fund, just prior to index fund rebalancing. The defined sets of rules are based on timing, price, quantity or any mathematical model. (For more on trend trading strategies, see: Simple Strategies for Capitalizing on Trends.)