Basics of Algorithmic Trading
A sequential process with a well-defined set of rules for problem solving operations is called an Algorithm. Algorithm is widely used in Mathematics and Computer world. It was named after the Persian mathematician Muhammed ibn Musa al-Khwarizmi who was a scholar in the House of Wisdom in Baghdad between the period 813 and 833.
Algorithm Trading or Algo Trading is the way of using computer softwares which are designed on certain sophisticated algorithm to place orders in the Electronic Trading Platforms to Buy or Sell orders in the Stock Exchanges to make profit at a speed and frequency that is humanly impossible. Because of its high frequency, this kind of trading is also known as High Frequency Trading(HFT) when it is done via high speed network in colocation set up which is close to the matching engine of exchange to reduce the latency (time taken) in sending order. Colocation set up are the Exchange owned datacentre where its specific set up racks are leased to trading members for HFT. The distance between trading member datacentre from the Exchange matching engine will be always more than that of the Exchange’s own datacentre (also called colocation) from its matching engine. Thus colocation set up has reduced latency advantage over the trading member servers hosted in their own datacentre.
Benefits of Algo Trading
- Trades are executed at best possible prices irrespective of buy or sell.
- Trades are executed accurately as these are triggered by computer generated programs minimizing the earlier manual ways of incorrect data feed to trading screens by human errors.
- It also reduces the cost of employing manual traders. This cost also known as transaction cost which is given to traders for continuously monitoring the market till orders gets executed
- It removes the human emotions in trading decision while participating in the market. Human traders were traditionally tempted to invest more while market going up and withdraw the investment while market going down which was leading to irrational decision making rather than sticking to the initial plan.
- It can be back tested on historical data to observe its behaviour to make the best use of it in current scenario.
- It can perform simultaneous automated checks on multiple market conditions and place the order to profit worthy market.
Risks of Algo Trading
- It does not work when there is a network break down between trading system to exchange. Network connectivity needs to be restored to resume Algo trading
- It does not work when there is a system failure due to any issue at the server where the Algo trading system is hosted or due to any database failure which stores it data.
- Breaking news globally can change the mood of stock market intraday and render the Algo insignificant which is mostly designed on historical trends in market.
Algo Trading Strategies
The various approaches or combination of algorithms with which algo trading is done are called algo trading strategies. There are different types of Algo strategies available in the market. Some of the popular Algo Trading Strategies are: