Algorithmic trading is fast becoming the traders’ choice, with both retail traders and big trading firms embracing this trading method. Nonetheless, some people find this form of trading complicated and may never get it right, ultimately losing money. But does algorithmic trading work?
Algorithmic trading works as long as you understand the trading strategy to use, which involves backtesting and validation methods. However, despite algorithmic trading reducing costs, it can worsen the market’s negative tendencies and cause immediate loss of liquidity and flash crashes.
In this detailed article, we’ll delve into detail about: What algorithmic trading is? How algorithmic trading works? Why algorithmic trading may or may not work?
IMPORTANT SIDENOTE: I surveyed 1500+ traders to understand how social trading impacted their trading outcomes. The results shocked my belief system! Read my latest article: ‘Exploring Social Trading: Community, Profit, and Collaboration’ for my in-depth findings through the data collected from this survey!
Table of Contents
What Is Algorithmic Trading?
Algorithmic trading uses chart analysis and computer codes to get into and exit trades based on set parameters like volatility levels or price movements. The trading algorithm can execute a buy/sell order once the current market condition matches the predetermined criteria. That saves you time checking the markets and ensures that the trades are executed instantly.
How Does Algorithmic Trading Work?
Algorithmic trading works through computer algorithms that use complex formulas combined with human oversight and mathematical models to decide whether to buy or sell financial securities.
Algorithmic traders use high-frequency trading technology to allow a firm to make thousands of trades per second. This type of trading can be used in different situations like arbitrage, order execution, and trend trading strategies.
Let’s look at how algorithmic trading makes for a better trading strategy compared to discretionary trading.
A Historical Backtest Is Done to Evaluate the Trading Strategy Performance
Algorithmic trading eliminates the guesswork from trading as it relies on historical backtests to check the performance of trading strategies. That enhances the chances of success. Discretionary trading depends on guessing how specific patterns should perform. Unfortunately, this method’s accuracy is not guaranteed, and traders using this method could lose their trade.
There’s no trading that allows you to use different styles like algorithmic trading. That is made possible because a computer executes all strategies; this method eliminates common mistakes most discretionary traders make in the process. You won’t have to deal with erroneous orders due to a lack of focus. Although you may encounter some problems from time to time, these issues are reduced with close monitoring.
Algorithmic trading strategies run throughout as long as the markets are open. You could use strategies that trade on different hours in the same market, which gives you an advantage. Furthermore, algo traders don’t have to spend a lot of time monitoring the markets as trades can be executed without continuous supervision. That reduces the time spent trading, something that translates into lower transaction costs.
Reduction of Emotional Distress
Most traders have to deal with the emotional and psychological aspects of trading. Trades are constrained within predefined criteria. Discretionary traders struggle to keep their emotions in check while still adhering to the set rules. That can make them rush to make irrational decisions. Algorithmic traders are not part of executing the trading strategies, which relieves them of the emotional pressure that comes with trading.
Diversification Across Markets, Strategies, and Timeframes
Algo trading means the computer gets to handle everything. That allows you to expand your trading into different markets, use various strategies, and explore different timeframes. The result is increased profit potential and superior risk management. Some algo traders use multiple strategies simultaneously, which means one strategy mitigates any loss another approach could make.
Why Algorithmic Trading May Not Always Work?
Although algorithmic trading enables a more straightforward and faster execution of orders, it also has its limitations and may not always work. Some of the reasons behind this are:
Liquidity Can Disappear in a Moment
Liquidity in trading is created through fast buy and sell orders. Unfortunately, with algorithmic trading, this liquidity can disappear when least expected. The result is that this could eliminate the chance for traders to profit from price changes. A good example is when the Swiss franc discontinued its Euro peg in 2015, which led to the loss of liquidity in currency markets.
Order Execution
Algorithmic trading is advantageous as one can execute multiple orders at the same time. However, this can also work against an algo trader when several orders are executed without human intervention. When you have a faulty algorithm, the results can be catastrophic as you may end up releasing hundreds of transactions in a couple of minutes. If anything goes wrong, a company may lose millions of dollars in that timeframe.
That could lead to a flash crash, which is a case where the withdrawal of stock orders amplifies price declines rapidly. The result here could be collapsed stock indexes. In 2016, another crash saw the British Pound plunged to its lowest in one night,
A good example is the flash crash in 2010 that saw computer trading programs react to market interference like selling large volumes rapidly and heavy selling in many securities to avoid losses.
Missing Out on Trades
Algorithm trading doesn’t show the signs the algorithm has been programmed to find, leading to a trader missing out on trades. Although this can be reduced to an extent by increasing the number of indicators the algorithm should look for, this list can never be complete.
Algorithm trading has a connection to market volatility. Although implementing control measures can prevent losses due to coded or poorly defined algorithms, there is still danger in allowing the computers to do all the work.
Algorithmic Trading Strategies That Work
Traders set trading strategies, although the trades are executed through a computer program. The trader gets to decide the volume, price, and time when the trade takes place.
Here are some algorithmic trading strategies that work:
Arbitrage Trading
Stocks are listed in more than one exchange, but the prices on these exchanges can be different. With arbitrage trading, a trader will seek to buy the stock on the low price exchange and sell it to the high-price trade.
Momentum and Trend
The momentum and trend strategy seeks to understand the price momentum in a specific direction and executes trades. This strategy assumes that the stock will continue to move in the same direction it’s currently in to enable the trader to determine the stop-loss or take-profit price for a particular stock.
That means when the price goes beyond detailed highs, it will stay above the prior swing lows, meaning the stock will be on an upward trajectory.
Is Algorithmic Trading the Future?
Companies embracing technology are beginning to experience more success than those who’ve stuck to the old way of doing things. The same applies to trading. Succeeding as an algorithmic trader is more compared to the odds of succeeding as an individual discretionary trader. Nevertheless, it’s essential to understand that although the chances of making profits are high, there are risks and a learning curve involved.
Investors need to understand that there are risks to algorithmic trading like network connectivity errors, system failure risk, incorrect algorithms, and time-lags between trade orders and execution. It is therefore essential that proper backtesting is done when one is dealing with a complex algorithm.
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Conclusion
Algorithmic trading works as long as you understand the risk management techniques, conduct proper backtesting, and use validation methods. Algorithmic trading may fail to work because some people don’t understand the trade techniques, which means they lose money. The best thing about algorithmic trading is that it allows you to know the systems that failed and those that have worked. That can help you increase your income and reduce the risk of losing money.
BEFORE YOU GO: Don’t forget to check out my latest article – ‘Exploring Social Trading: Community, Profit, and Collaboration’. I surveyed 1500+ traders to identify the impact social trading can have on your trading performance, and shared all my findings in this article. No matter where you are in your trading journey today, I am confident that you will find this article helpful!
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