Algo Trading: The future of Trading and its benefits…!!
Rapid technological changes have impacted every section of the society. Even the financial world too has felt the impact of technological innovation. With the advent of Blockchain, AI and IOT have completely changed the entire financial industry. Trading too has felt the impact of technological innovation. Financial trading floors are experiencing a huge transition. Algo trading is replacing traditional trading floors. The process of using computer programs to automate the process of trading (buying and selling) of financial instruments such as stocks, currencies, derivatives or cryptocurrencies at a much faster pace than humans. The percentage of volume trades attributed to algorithm trading is on the rise. It has given traders more power to do faster execution with discipline in a rapidly changing financial environment.
In India too, Algo trading has witnessed rising interest in the share market from both domestic and international investors. It provides liquidity in the market and makes trading more systematic by eliminating any kind of emotional involvement in trading activities. SEBI permitted automated trading in 2008. Afterwards, the number of firms using algorithmic trading has been on the rise, with current estimates putting the figure at 50% of the total volume.
Algorithmic trading strategies:
There is a general belief that algorithmic trading is designed for high-frequency trading. But not all, algorithmic trading is designed for high frequency trading. There are a variety of algorithms apart from arbitrage & market making algorithms that are designed by institutional investors as well as retail traders to trade in the market. Let’s look at the type of trading strategies employed:
- Momentum/Trend Following: – It is generally used to capture strong moves in short time frames usually for not more than a few hours or a few days. The algorithm seeks to find a trend in the company’s stock price by using different technical and quantitative indicators to analyze the available information. Once these trades are identified, the trader can place a trade depending on the perceived profitability of the strategy.
- Statistical Arbitrage: It is a strategy used by traders to benefit from aberrations in prices of two or more financial instruments that are related or similar in nature. A simple arbitrage would be between a stock trading on two different exchanges at different prices or a stock and its futures.
- Machine learning-based algorithm: It has become one of the key elements in the algo trading system. It uses historical data of the markets and feeds this to the machine learning algorithm that they have designed. The historical data is divided into training data and testing data. After training, the machine learning algorithm learns the pattern and features from the training data and trains itself to take decisions like identifying, classifying or predicting new data or outcomes.
Algorithm trading encourages a systematic pattern of trading and it rules out the possibility of human errors. Let’s look at the other benefit of algo trading:
- Speed: Speed is one of the main characteristics of Algo trading. Algorithms are composed in advance, so one can execute the guidelines consequently. The primary advantage of doing this is speed, as it is difficult for humans to match the machine speed.
- Accuracy and Precision: Accuracy is one of the most important features of algorithmic trading. It is the key to better results. With the use of computers in trading, it will reduce the errors caused by humans. Algo trading diminishes a few errors that may occur, when trade is performed manually.
- Diversify Trades: Algo trading allows to diversify trades with mechanized exchange of frameworks, which allows the client to exchange multiple accounts or use different techniques at one time. The computer can scan for trading opening over a scope of business sectors.
- Reduction of Cost: One of the benefits of algo trading is reduced transaction costs. The lack of human interaction helps in dramatic time reduction for trading, which subsequently saved the opportunity cost of constantly monitoring the markets.
- Back Testing Ability: Back testing allows traders to evaluate and fine-tune a trading idea and to determine the system’s expectancy- the average amount that a trader can expect to win or lose per unit of risk. Any trader can take these precise sets of rules and test them on historical data before risking money in live trading.
*Disclaimer: investment in securities market are subject to market risks, read all the related documents carefully before investing