The world of trading has changed a lot. From the time people had to fill slips and stand in the queue to submit bids to today, trading has undergone a sea change. Major credit for this goes to retail investors, who till recently shied away from the markets. But whose proliferation in recent years has prompted big investors to devise something innovative that can give them an edge, Algorithmic trading.
As retail investors start to enter stock markets around the world with hordes of cash, anticipating quick gains, big institutional and standalone investors were quick to guess that retail investors far outnumber the handful of big investors. And, when retail investors put in or take out money, the stock prices can face large-scale volatility, which might result in an unpredictable upswing or downswing.
Hence, they started to feel the need for a mechanized trading system that can take away emotions out of trading and make it completely data-driven, which can be sensitive to minor price and volume fluctuations to facilitate apt decision-making.
Algorithmic trading, also known as algo trading, gives seasoned traders and big institutional investors the edge they want over retail investors, who are often misinformed, and get swayed by emotions. Read on to find out how algo trading is changing the nature of money-making and why the trading fraternity has been going gaga over it.
What is Algorithmic Trading?
Algorithmic trading is a computer-programmed systematic trading method that executes trades automatically without human intervention. It accurately identifies the tick to tick movement of a stock price and automatically executes an order when the pre-programmed criteria are met.
As trading is a zero-sum game, missing a tick can mean losing millions in hard cash. Hence, time and price play a significant role in order execution. With algo trading, entering a trade is as easy as exiting it.
Algo trading is precise, quick, reliable, and efficient. It eliminates errors by reducing human interference in placing orders. No wonder, the algo trading industry is slated to be a US$ 21,685 million industry by 2026.
The Mechanism of Algorithmic Trading
Algorithmic trading uses multiple factors that determine the price movement of a stock and creates a program that automatically picks stocks meeting those criteria and executes orders.
Let us understand this with an example.
Let us assume that you use 9, 50, and 100 days’ simple moving average (SMA) to enter or exit a stock. Algo trading would simplify the process for you by creating a program that accurately calculates the average of the said SMAs and places a buy or sell order when the price crosses the average price point. As many Algo trading software allows you to set your own parameters, you can also include other indicators, like volume, to make it even more efficient.
Algo trading, of which high-frequency trading is a part, automates the process of picking stocks and placing orders. And all of these are not new. Way back in 2010, high-frequency trading controlled as much as 60% of the total trading volume.
Buy or Sell Stocks Without Major Disruptions
The massive popularity of Algo trading can be attributed to institutional investors like pension funds, hedge funds, insurance companies, mutual funds, and high net worth individuals. As sudden large-sized buy or sell orders can cause abnormal price movements, the institutional investors use algorithmic trading software to break the trade down to small-sized orders that buy or sell stocks without any major disruptions to its price.
The latest innovations in technology have made algorithmic trading more reactive to human-induced price movements. For example, many software automatically scans real-time news, arbitrage opportunities, shifting trends, and sometimes, speculation, to predict future price movement. Hence, filtering out stocks that display a prominent trend becomes easy with an Algo trading system.
Algo trading, unlike human trading, places orders to the stock exchange in macro seconds or milliseconds interval. Hence, traders can leverage the real power of bid-ask spread to gain from even minor price movements.
The Benefits of Algorithmic Trading
Now that you know how algo trading works, it’s time you should get an idea of how it impacts the trading business.
1. Eliminates Emotions
Winners master the art of exiting loss-making trades early and letting the profits run, which normal investors and traders rarely do. An algo trading software allows you to replicate the art of winners. It automates the entire process of stock trading, right from stock selection to profit-booking, thereby reducing the complexity of trading.
2. Reduces Dependence on Technical and Fundamental Analysis
Ask any investor what prompts them to pick trades, and they would respond with fundamental or technical analysis.
As too many investors rely on the two most popular analysis methods, it has lost most of its relevance, and to accurately predict stock price movements, you have to be a master of the art. As algo trading automatically includes the best of fundamental and technical analysis, it minimizes the need for mastering the methods of analysis. Hence, it takes decisions that are unlikely to be replicated.
3. Enhances Speed
In stock trading, speed matters more than anything else.
Algo trading gives speed a new meaning. As orders get placed and executed faster than the blink of an eye, getting in and out of profitable trades can be an affair of no more than a few seconds. This remarkable feat is rather impossible for a human trader.
4. Scans Unlimited Stocks, Derivatives, and Indices
What humans cannot a computer can. While a human can’t scan multiple stocks and derivatives at the same time, it is fairly easy for an Algo trading software. Hence, algo is giving traders an excellent edge in spotting trades that matter, just at the right moment.
5. Provides Near-Accurate and Flawless Entry and Exit Targets
In manual trading, there can be a disparity between the spotted price and the order price, which can make all the difference between profit and loss. As algo trading makes entering and exiting trades easy, you can expect the entry and exit targets to be flawless. Hence, by improving accuracy, Algo trading is changing the way prices move.
6. Saves Money
Almost all sectors offer opportunities to earn money, either by going long or by shorting. But identifying opportunities as they happen can be tricky, as you might require more than one computer and multiple associates to figure out the opportunities for you.
Algo trading simplifies the process by filtering stocks that meet the pre-defined criteria. As investors put the extra money they save due to an Algo trading software on stocks, the market becomes a better place to trade and make money.
Trading in the stock markets can be remunerative if you identify price movements that are not visible to the naked eye. Algorithmic trading lets you do exactly the same.