Algorithmic trading uses a computer program process to place a trade order. It is a way of trading that relies on programs and codes to maximize profits and avoid human errors. This helps traders to make profits at a better rate. New rules proposed by the Security and Exchange Board of India (SEBI) are aimed at giving confidence to this area of trading. This type of trading provides more liquidity to the market. Algorithmic trading is the main source of income for Bombay Stock Exchange (BSE) and National Stock Exchange (NSE). Important factors to be kept in mind are price, quantity, timing and mathematical model.
Identifying profitable trading opportunities
If a trader follows a trend of buying 50 shares of stock when the 50-day moving average is above the 200-day moving average. And consequently sells the stock when 50-day moving average is below 200-day moving average. A computer program can be written to place the order with the help of above strategy. It makes buying and selling easy. This also eliminates the need to monitor live prices and graphs. It also helps a trader in identifying profitable trading opportunities.
There are many benefits of this type of trading. It reduces the transaction cost. This also helps a trader to execute transactions at the best price. Helps to place an order correctly and instantly. Also helps to reduce the manual errors in trading. This takes the human emotion factor and the errors committed due to it out of the equation.
Mid to long term investors use algorithmic trading. Pension fund or mutual fund firms and insurance companies also use algorithmic trading. Algorithmic trading is also popular with short term traders and participants like market makers, speculators and arbitrageurs. Arbitrageurs are traders involving in arbitrage. Arbitrage is buying and selling of securities, currency, or commodities in different markets due to a difference in price listed. This sale translates in profits and is easily possible in algo-trading.
Technical indicators used to formulate a strategy for algorithmic trading are moving average, channel breakout or price level movements. These strategies are simple and they do not involve price forecasting or any prediction. The program takes into account essentially two benchmarks viz. simple moving average and the exponential moving average.Simple moving average is the moving average of a security over a pre-defined time period. Exponential moving average on the other hand gives more weightage to recent prices in the average.
Algorithmic trading is very popular for High frequency trading (HFT). The trading capitalizes by placing large number of orders at very fast speeds. The orders are placed across multiple markets and based on multiple design parameters based on pre-programmed instructions. The orders so placed are beyond human capabilities. A machine is needed to process the orders at the speed required for these transactions. This systematic approach to trading based on factors other than human intuition or instinct is a major advantage.
This way of trading does have its shortcomings. There are problems like network connectivity, system failure, time difference in trade order and its execution. There also the risk of an inappropriate algorithm being created that can sink all profits.