It’s All in the Algo — A Brief Explanation of Algorithmic Trading

Although the origins of algorithmic trading can be traced back to the mid 1990s, for many individual traders, the practice is still shrouded in mystery. However, as markets change and become ever more data reliant, it seems that there’s no stopping the rise of algorithmic trading and its associated technologies. But what exactly is algorithmic trading and how does it work? Here, we take a quick look at the rise of the machines and how they might shape markets in the future.

What is Algorithmic Trading?

Put simply, algorithmic trading employs computers to process complex formulae designed to follow a specific set of instructions. These instructions are based on variables such as time, price, and volume among many others. For instance, you can write an algorithm that sells a specific stock if it ends in losses over 10 days or buy a stock if market liquidity increases over the same period. However, the overall aim of algorithmic trading is to execute high frequencies in lightening quick time—much quicker than any human might be able to. ­

There are currently hundreds of thousands, if not millions, of algorithms that are based around a broad range of data sets; and anyone, in fact, can author their own. This is perhaps why so much confusion surrounds this type of trading, with a seemingly unlimited scope for the buying and selling of orders. Historical data sets and statistical analysis are seen as particularly promising areas of algo trading, with formulae designed to ditch poor strategies automatically by making predictions based on previous market behavior.

Advantages of Algorithmic Trading

Some of the advantages of algorithmic trading are probably fairly obvious. Firstly, the reduced potential for human error, bias, or manipulation means that markets should, in theory, be more stable. Secondly, trades can be executed faster, more reliably, and at the best possible prices, with reduced transaction costs helping to sweeten the deal. Additionally, instant orders can be placed with high degrees of accuracy to give traders a better chance to execute at preferential levels.

Algorithmic Trading and Regulation

Among the less obvious benefits of algorithmic trading is its potential to provide the requisite proof of best execution. As market regulations become more comprehensive, and particularly in light of the MiFID II framework, the sell-side is obliged to provide more information than ever before. The data based nature of algorithmic trading makes this process easier by removing the human element and providing continual and accurate data to support choices made.

What Does this Mean for Individual Traders?

It is estimated that something like 70% of all trades are currently executed using algorithms—and it looks as though they are here to stay. It is also thought that algorithms will continue to grow in number and complexity, meaning that everyone within the industry should at least have a rudimentary understanding of how they work and the implications they bring. Whether learning to build your own, or simply selecting a few existing algorithms to become familiar with, it is important to be aware of their existence.

For anyone wishing to try their hand at algorithmic trading, then a broker neutral platform such as this will provide the right tools for the job. With an open architecture to create and deploy complex strategies and access to algorithms from brokers and other third parties, traders have the opportunity to study and experiment with algorithmic trading. Naturally, as with any type of trading, the goal is to make a profit but in the complex world of algo trading it is important to understand the fundamentals first and build a winning strategy from there.