What is Algo Trading?
Created on 06 Jun 2019
Wraps up in 4 Min
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Updated on 05 Jun 2021
In a world where everything is computerized, why not use the same line in trading?
While science and technology constantly spread their branches, there isn't one area to leave its mark. And the world has benefited tremendously from its brainchild.
To be successful with your investments and bag some profits, you will need to spend a lot of time analyzing each stock and executing the action at the right time. This is becoming increasingly difficult owing to the time constraint we have. Having filled many tasks from work to family, you might be left with no time to run such an analysis.
But does that mean you can't invest and make some good gains out of it? This is where Algo trading comes into play. Algo or Algorithm trading enables you to computerize your trading activities. Confusing, right? Chill. Because we will explain every bit of it to you.
What is Algo trading
On average, about 75% of the entire trading population uses some algorithm to enhance or support their trading activity globally. This number stands at around 70% in India alone. Having said that, you might be wondering what's so special about it and what makes investors use it? But first, let's have a glimpse into the mechanism as such.
Algo trading uses a computer program to analyze and execute trade activities on your behalf. All you have to do is feed a set of rules and strategies in computer language, and you are all set to go. Introduced to Dalal Street in 2009, it is used by institutional, international, and domestic traders.
How does Algo Trading works work?
For instance, say you are planning to invest in the stocks of XYZ company. Your strategy is to buy whenever the price falls below the 7 DMA (Day Moving Average) and sell it when it falls below the set price. Apart from that, you also have a specific stop-loss figure in mind. But due to various reasons, you cannot correctly track the markets and keep track of the different price movements.
In such a scenario, you can use one of the tradings among the many available in the market and feed all your conditions and strategies into it. Now the algorithm will take care of analyzing and the timely execution. The rate of manual interference can also be determined by the investor himself.
In the case of users who rely on zero manual interference, the system or the strategy engine will take complete control of your trading activity. It will determine the position and directly contact your broker to execute your orders on your behalf. However, it's important to note that different brokerages impose different rates for such trading.
Should you use Algo trading?
Such an algorithm bears numerous advantages, and we will see them in detail.
- The time required is minimal. Hence, you don't have to spend hours analyzing and tracking the performance. Your software will do that on your behalf.
- Prompt execution increases your possibility of making a profit. In manual trading, the time taken to execute a trading activity might be turntables. You will end up in a bad state if the price passes the one you had on your mind by placing the order. On the other hand, the software acts quickly to fulfil the execution.
- It also reduces the human error involved. As time passes, we might tend to lose sight of our goals. We might give in to fear or greed and ultimately land up in a loss as a result. With a computer in place, the probability of such an event happening is less.
- Your strategy can also be back-tested and refined to bring you success.
- It reduces the transaction cost as well.
- It offers investors an opportunity to scan and analyze many stocks or positions at any given point in time.
Algo trading has its own set of drawbacks as well. Some of them are given below.
- Algo trades can cause many disruptions by mass buying and selling activities, resulting in a market fall or crash.
- Small algo error, bug, or default can cause heavy trader losses and affect the market significantly.
However, SEBI has brought in stricter rules and regulations to help the entire system function smoothly. With that in hand, one cannot turn a blind eye towards the increased liquidity and ease of use it provides. Further, they come in handy if you are dealing with massive loads of stocks daily. With analyses and constant trend-related updates, they prove to be more beneficial than the other way around. However, you should learn enough about the software itself before jumping into it.
The investor can base his Trading strategy upon price, volume, etc. Below mentioned are some of the popular trading strategies which are used in algo trading.
- Trend identification – Here, the historical data is analyzed, and updates regarding a probable trend are notified to the investor. As mentioned earlier, such a technique comes in handy while analyzing vast chunks of data.
- Making use of arbitrage opportunities- Many traders buy stocks in one market at a low price and sell them in another at a higher price. This can be done across different instruments, and the entire process is simplified with the help of this software.
- VWAP and TWAP – Huge orders are broken down into smaller chunks and are executed by the software in smaller quantities. Such a strategy aims to use the Volume–Weighted Average Price (VWAP) or Time-Weighted Average Price (TWAP).
Hope you got a good grip on what Algo trading is all about. It is time to utilize your knowledge in the right way. While adapting to such a technology would give you an edge, only if your investment goals and portfolio would benefit from such a switch.
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