Educational

Algorithmic Trading 101: What You Need to Learn

A lot of us are coming to depend ever more on computers and technology than ever before, and investors are no exception. Algorithmic trading is a type of trading done with the use of mathematical formulas run by powerful computers.

Algorithmic Trading on two adjacent pale blue buttons.

Algorithmic trading makes utilize of much more complex formulas, combined with mathematical models and human oversight. To make decisions to buy or sell financial securities on an exchange.

Algorithmic trading is not an attempt to make a trading profit. It is just a way to minimize the cost, market impact and risk in execution of an order.

It is broadly use in investment banks, pension funds, mutual funds and hedge funds. That because these institutional traders need to execute large orders in markets that cannot support all of the size at once.

Algorithmic traders often make utilize of high-frequency trading technology, which can allow a company to make tens of thousands of trades per second.

What is Algorithmic?

An algorithmic is set of directives for solving a problem or completing a task. One usual example of an algorithmic is a recipe, which consists of specific instructions for preparing a dish/meal. Every computerized device utilizes algorithms to perform its functions.

How algorithmic trading works?

An algorithm is a procedure or set of defined rules designed to achieve a certain process. Algorithmic trading uses computer programs to trade at high speeds and volume based on a number of preset standards, such as stock prices and particular market conditions.

For an example, a trader may use algorithmic trading to carry out orders quickly when a certain stock reaches or falls below a particular price. The algorithm may dictate how many shares to buy or sell based on such conditions. When a program is put in place, that trader can then sit back and relax, knowing that trades will automatically take place once those preset conditions are met.

Types of Algorithmic Trading Strategies

Since there are various algorithmic trading methods for both trading and investing, to help, we thought it would be a good idea to share several of the most common and important approaches for financial advisors and investors.

Momentum investing

Momentum investing strategy is one of the most basic and common algorithmic trading systems followed by an investors. This is type of investing looks for the market trend to move importantly in one direction on high volume.

 This trading system can either be very easy or significantly difficult. A simple momentum investing strategy may invest in the five finest performing shares in an index that is based on a 12-month performance.

A more difficult strategy might mix momentum over time, making use of both relative and absolute momentum. Furthermore, using this system allows investors to rebalance momentum systems weekly, monthly, quarterly, or even yearly.

Mean revision

Mean reversion systems utilize the tendency of many asset prices to return to the mean after periods where they become weaken overvalued or overbought. Investors following this strategy generally presume that the value of the stock will eventually return back to its long-time, average value. They will buy assets when they trade at the lower end of a trading range. And, when the assets proceed toward the center of the trading range or a moving average, investors decide to sell them.

Factor-based investing

Factor-based investing is a strategy used by investors to choose safeties on attributes that are connected to higher returns, based on historical data.

In this system, there are two main types of factors that have driven returns of stocks, bonds, and other factors. Important factors include market capitalization, momentum, earnings momentum, beta, and free cash flow.

 Several financial investors will combine these factors using a static weighing system, or a dynamic allocation.

See also: Asset Allocation: How Much Should You Invest in Stocks and Bonds?

ETF word on cube wooden block on grid line paper, random block in the background.

ETF rotation strategies

Some investors decide to use Exchange traded fund, or ETF, rotation strategies to improve return for a certain level of risk. Investors can do this in many ways. The strategies rotate into ETFs with strong momentum to maximize return.

These strategies can also move capital into unrelated ETFs to control risk when there are volatile market conditions. Investors use these strategies to take full advantage of patterns and trends uncovered by quantitative research, in addition to the low fees charged by ETFs.

Smart Beta title on business document. Business concept.

Smart beta

Smart beta is a strategy used by investors in an endeavor to near the gap between active and passive investing. The aim of using a smart beta strategy is to lower risk or rise diversification at a lower price than what it would be with traditional active management.

This strategy highlights taking investment factors or market inefficiencies in a transparent and rules-based way. A lot of investors favor to use smart beta systems for portfolio risk management, diversification, and since the strategies can be packaged as ETFs, which are rebalanced every three months.

A market capitalization based on the index can use fundamental metrics and other elements to be reweighed. The smart beta strategy applies to asset classes outside of equities to include fixed income, multi-asset classes, and commodities.

See also: Low risk investments offering high returns

Trend following

When it comes to algorithmic trading systems, trend following is one of the oldest strategies used by investors. This strategy includes algorithms monitoring the market for indicators to perform trades.

In general, these trades use technical analysis and market patterns and indicators to make choices. The aim of this strategy is to purchase assets when prices break significant resistance levels and sell short assets which fall below important support.

This algorithmic trading strategy is popular among investors because of its functionality and ease of use compared to other algorithmic trading strategies.

Text Sentiment analysis on white paper / business concept.

Sentiment analysis

Sentiment analysis trading strategy is determined by crowd reactions, as investors stay up-to-date on latest and appropriate news and buy stocks to forecast the crowd’s reactions. The aim of this strategy is to take big quantities of unstructured data, like newspaper articles, reports, social posts, videos, blog posts. A lot of advisors and investors use this strategy to capture short-term value changes and get fast benefits.

Statistical arbitrage strategy

Statistical arbitrage systems made up of a set of quantitatively driven trading strategies. These strategies to look exploit the comparative value movements across thousands of financial instruments by analyzing the price differences and the price patterns. Investors utilize this strategy to cause higher-than-usual profits.

Seasonality strategies

Investors might choose to make strategies based on the time of the year. Several investors are aware that markets generally have better returns at the end of the year and during the warm, summer months.

They also may be aware that September is usually a month with the lowest returns. To avoid capital loss, some financial investors and advisors might choose to sell their positions with losses towards the end of December to benefit from tax leniency.

In addition, stock prices trend differently near the holidays and closing quarter periods. Investors who use this strategy should keep in mind that seasonality does not exist in one market, instead, only individual seasonal patterns exist.

Scalping

Scalping is another usually used algorithmic trading strategy. This again is a type of arbitrage where you see the scalpers profiting from the difference between the bid and ask price. It is also known as the bid-ask spread.

However, the beauty of algorithmic trading is that the scalper is not happy with just one trade. There is repeated scalping at very short intervals. As a result, you have a number of trades in a very short time. Moreover, all the trade is made with the concept of deriving the maximum likely advantage from the price difference.

These individual trades often take place within minutes of each other. That is how you can optimize the profit potential using the algorithmic formulas. While you are undertaking scalping strategies, you can also look at transaction cost factors too. They too suggest some reasonable scalping opportunity, particularly across markets and asset classes.

The broad idea remains simple. Don’t let a single change in asset pricing go with no yielding advantage to you. But one significant factor in this is you have to take some very fast and form choice. That alone will help deliver the desired results every time.

Factors Driving Stock Price

As the name indicates, the stock price movement is determined by a series of factors. The trader often tracks the varieties of factors and looks at drawing a significant profit from the price difference.

That, of course, is intentional out through executing applicable algorithmic trading strategies. The factors have a extensive range of likelihood and potential. It can be any element that drives up the price or pushes it down. As a result, you might see momentum, earnings, beta trends and cash flow issue influencing prices.

As a result, you can use these elements individually or in combination with other dynamic strategies. These factors can individually affect allocation to a large extent. Usually historical data is taken as a crucial benchmark in this case.

The price momentum or movement is calculated on the basis of that. The algorithmic trading strategy here looks at how best the individual factors determine a better pricing power to the general stock price.

The aim remains same across a range of algorithmic trading strategies. You have to maximize profits through fast and sufficiently of trades in a specific time zone. That is what makes it a profitable opportunity across asset classes.

Benefits of algorithmic trading strategies

There are some distinct advantages of incorporating algorithmic trading strategies to broaden your base and portfolio profit.

1. Automated

This is a totally automated trading opportunity. As a result, trade profits on its own as when the pre-determined price points. So it allows quick and effective trading.

Investors do not have to bear the effect of their indecisiveness in any way. The computer does the thinking and execution for the trader. All you have to do is install the right program that will yield the desired result.

2. Fast Paced

The automation also goes an extended way in making these trades rapid and precise. There is a much higher example of order placements at any given point. This increases the probabilities of the order getting executed at your desired rate. That assuredly improves the general profit potential.

3. Lower Transaction Expense

This kind of trade also lessens the total transaction price involved. By trading off the real-time market, they can save the price of the transaction.

 At the same time, they also give you the benefit of delayed execution cost. As a result, the strategy also controls the trading volume in this county.

 When the stock moves higher, the targeted participation increases. When the prices move down, the participation decreases too. Needless to mention, that has an adverse effect on the overall stock price and sentiment.

Conclusion

Algorithmic trading and investing include a number of strategies. Several of these strategies are concentrated on making long-term returns, while others are more concentrated on short-term returns. Many algorithmic trading strategies, like the ones above, are great for investors and advisors who are looking to optimize long-term portfolio returns while eliminating risk.

Therefore, if you are looking safe and stable gains, algorithmic trading strategies may be ideal. They take away human emotion and bring in lots of stride and volume based surge in your prices. It often helps the market too to identify larger chunks of price movement that you can profit from.

But at the end, remember that algorithmic trading is a profit-oriented program. This profit is, however, topic to many factors. So back testing the authenticity of the program is crucial before you commit cash to algorithmic trading strategies.

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