ALGO TRADING: WHAT IS ALGO TRADING & IS IT PROFITABLE FOR TRADERS?

What is algorithmic trading?

In algorithmic trading, a trading strategy is converted into a computer code (with a programming language such as Python, C++ etc.) in order to buy and sell shares in an automated, fast, and accurate manner. Owing to its speed and accuracy, automated trading has become quite popular across the globe.

After coding the trading strategy, you can connect with your broker for placing the trade orders. Further, the algorithms will keep placing the trades as per the programmed conditions (for buying and selling) until the algorithm reaches the exit point.

Let us see the algorithmic trading process with an example. Here, we will take the example of “Reliance” and see a simple trading strategy one can use.

An algorithm can be programmed to buy Reliance (NSE ticker: RELIANCE) shares if the share price is above the 200-day moving average (according to moving average trading strategy) of the stock.

Alternatively, the algorithm would sell the Reliance shares if the current market price is below the 200-day moving average of Reliance and hence, exit the market.

Let us see the above mentioned steps clearly one by one below.

1. First of all you need to get the historical price data of the stock. In our case, we have taken the example of Reliance as the stock. You need to get the historical prices of the Reliance.
2. Secondly, you need to compute the 200-day moving average of Reliance stock.
3. Then, you will find out if the last traded price of Reliance is above the 200-day moving average or below the 200-day moving average.
4. If the price of Reliance is above the 200 day moving average, then you will buy the shares of Reliance stock. This is an indication of an uptrend and the expectation is that the uptrend will continue.
5. If the price of Reliance falls below the 200 day moving average, then you will close your long position in the shares of Reliance and exit the market.

Globally, 70-80 percent of market volumes come from algo trading and in India, algo trading has a 50 percent share of the entire Indian financial market (including stock, commodity and currency market).

Profitability with algorithmic trading

You have already seen how algorithmic trading is profitable with regard to helping you save time and efforts.

Also, algorithmic trading offers accuracy when it comes to predicting the trade positions (entry and exit). When you do algorithmic trading, the trading decisions or strategies (to buy and sell the financial instruments) are made after taking into consideration several factors which make the strategy logical and hence, more accurate than manual trading.

Let us see some of the factors below which are taken into consideration while creating the algorithmic trading strategy:

• Mathematical and quantitative tools such as Probability, Regression, Calculus etc. are used for creating the trading strategy.
• The strategy needs to be backtested on the historical data which helps discover the viability of the strategy based on its performance on the past data.
• The risk management should be in check as the risk usually arises when the market moves in the opposite direction from the expectations of the trader. There are several factors that may make the market move in the opposite direction such as elections (political), change in the technology (business) etc. Hence, you must trade in the market only after weighing the anticipated risks with your anticipated gains. One of the instances of a sudden event that led to a huge impact on the financial market was Covid-19.

Coming to the profitability with algorithmic trading in terms of returns, it is a must to mention that the returns completely depend on the trading strategy that a trader builds which is then coded with the help of a programming language. Nevertheless, algorithmic trading helps you carry out multiple trade orders simultaneously and also the algorithm can enter and exit the market according to your conditions at a great speed which increases the probability of better returns. The speed at which algorithms can trade can not be matched by any human.

• Zero human emotions
• High accuracy and speed
• Scalable
• Portfolio and risk management

An algorithmic trading strategy is created with mathematical and quantitative calculations and hence, the algorithmic trading does not get influenced by emotions (fear, greed, anger etc.) and instead depends on logical decision making.

SEBI has formed an internal working group to discuss on issue regarding unregulated algos used by investors and how to prevent them. In the consultation paper, SEBI has proposed a framework which may be considered by algo trading done by retail traders.

Conclusion

Algorithmic trading is a useful contemporary concept that is being adopted across the globe. For using algorithms, you need skills such as programming, trading experience, knowledge about mathematical and quantitative logic etc. Last but not the least, algorithmic trading is more fast and more accurate as compared to manual trading which implies that the future of trading with algorithms looks to be bright.

Source: Business Standard, National Institute of Financial Management, Wikipedia

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