Early man had to walk or ride on animals to get from one place to another. Then, the wheel was invented, and suddenly, travel became a lot easier and faster. Slowly, the steam engine, cars, and airplanes were invented, each making travel that much faster and rendering the previous version obsolete. Today, it is possible to get from one corner of the world to another in a few hours. In the trading world, algorithmic trading represents this change from walking to using airplanes. In this article, you will find out what exactly algorithmic trading is, its history, the pros and cons of algorithmic trading, as well as its prospects.
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What is Algo Trading?
Before you think about how to learn algo trading, you need to understand exactly what algo trading is. Put very simply, algorithmic trading is when a computer trades on your behalf based on a computer program. This program(algorithm) is created by you, and the computer executes it based on your specifications. For example, suppose you trade on a simple strategy: buy when the 50-day SMA is above the 200-day SMA, and sell when the 50-day SMA is lower than the 200-day SMA. Using algorithmic trading, you won’t have to constantly monitor live prices anymore, as your computer will automatically open and close trades whenever these conditions are satisfied.
Algo trading platforms also allow you to open and close positions on several instruments simultaneously, thus generating profits at a speed and frequency that cannot be matched by human traders. This is why algo trading platforms and strategies are now becoming increasingly popular in trading circles.
How Did Algorithmic Trading Come About?
In the original stock exchanges, trading was done in pits through the ‘outcry method’. Traders would either shout or use hand gestures to indicate the names of the stock and their bids, and other traders willing to trade at these rates would then buy/sell the stock. Gradually, this gave way to telephonic trading, wherein traders called brokers and asked them to open/close positions for them. Eventually, sometime in the 1980s, there began a paradigm shift towards electronic trading. As of today, the vast majority of exchanges around the world are electronic.
As trading became electronic, traders could now place orders using their terminals at the click of a button. The order would go directly to their broker, and the order would be executed via the computer by finding buyers/sellers across the market. As you can imagine, this greatly sped up the trading process, as trades could now be carried out in seconds. With time, even this wasn’t fast enough, and people started developing computer programs that could trade in their stead. All they needed was a broker, a connection to an exchange, and a program that could place and execute orders for them. This gave birth to algorithmic trading, and positions can now be opened and closed in a fraction of a second, rendering human traders slow and inefficient in comparison.
Pros of Algorithmic Trading
Algorithmic trading has several advantages, most of which have to do with the fact that computers and algorithms do not make the same mistakes that humans often tend to make. For one, algo trading platforms usually allow you to backtest algorithms to identify whether or not they are a viable trading strategy. In the backtesting process, the algorithm is run on past data to see the results that would’ve been obtained if the strategy had been employed in the past. This is an incredibly useful tool as algorithms can then be tweaked to give optimal results using historical and real-time data.
Another advantage of algorithmic trading has to do with its speed. It ensures that your orders will always be fulfilled at the best possible prices and situations, resulting in the maximum profit for you. No longer will you be losing out on trading opportunities because it took too long for you to hit the ‘place order’ button, because when you use algorithmic trading platforms, this happens automatically and instantaneously, ensuring that orders are fulfilled at your desired price levels.
Lastly, algo trading strategies take out the human error factor from the trading process. This means that the possibility of you losing money as a result of mistakes that humans make due to emotional or psychological factors will be minimized. Remember the trade you lost money on because you kept increasing your stop loss, hoping the price would turn? With algorithmic trading, it wouldn’t have happened, because algorithms are devoid of emotions, and consequently, of emotional biases.
Cons of Algorithmic Trading
While algo trading has several advantages, there are just as many disadvantages to it, and being aware of them can go a long way towards stopping you from incurring losses. For starters, backtesting doesn’t always produce reliable results. A lot of traders fall for what is called the hindsight bias, assuming that whatever worked in the past should also work in the future. They tweak algorithms until they give amazing returns on historical data, however, the moment these algos are tested on real data, they fail. This is called over-optimization, and it is a very real phenomenon that any algo trader should beware of.
Another disadvantage is that algo trading programs, once developed, have to be constantly monitored and updated to reflect real-time market trends. Traders still need to watch the algo for any signs of mechanical issues, missing orders, or other errors that might indicate a problem in the system that would have to be dealt with. Granted, you will not need to be in front of your desk the whole time, but you’ll still have to keep checking your algorithms and servers every few hours to ensure that everything is running as planned.
Lastly, algorithms are computer programs. They function on a specified set of instructions, and they will follow exactly what you tell them: no more, no less. Hence, they’re unable to understand human behavior and sentiments the way human traders do, because they rely on markets acting in an efficient, rational manner. And no matter what academics say, any trader worth their salt knows that markets are anything but rational. In irrational market conditions, like the recent GameStop short squeeze brought on by Reddit traders, algorithms lose control and become erroneous.
Future Trends in Algorithmic Trading
It seems that algo trading is here to stay, but not quite in its current form. Algo trading strategies, when combined with machine learning, result in self-learning capabilities. This means that algorithms will be able to learn from their own mistakes and constantly optimize themselves, adapting to dynamic market conditions. They will also gradually become faster and faster, saving time on trade executions, and eliminating any possibilities of delays at all. As a greater proportion of trading begins to be done through algorithms, markets might even get more efficient, and panic buys/sells would reduce. According to Quantinsti, this might even mean that market crashes might become a thing of the past.
However, as algo trading becomes more and more common, this would also mean greater regulations and governmental interference. At present, countries across the world have different laws and rules on algo trading, but gradually the formation of a uniform code can be expected. Once this happens, it would be possible for algos to trade markets worldwide simultaneously, resulting in a higher level of interconnectivity between different financial markets worldwide.
In conclusion, algorithmic trading is the next big technological leap in the trading industry, and very soon it will render human traders inefficient and slow if it hasn’t already. There are some major advantages to algo trading, such as increased speed, efficiency, and the ability to backtest algo trading strategies before employing them in the real markets. However, they also require a high degree of technical knowledge, which makes it difficult for people to learn algo trading, and have their own set of disadvantages. It is important for you to understand the implications of algo trading even if you’re not planning on trading using algos because their presence will directly affect the efficiency and profitability of your strategies. You can learn more about algo trading strategies and connect with like-minded traders on social media platforms like algo trading Reddit subreddits.
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