Prior to the proliferation of online trading brought about by the internet boom decades ago, traders had limited options for execution and analysis. As online trading became the industry norm, an increasing number of brokers and technology providers emerged with numerous unique offerings, expanding a trader's options. A similar industry shift has been playing out over the past few years as algorithmic trading has become more accessible, giving traders a new swath of markets to trade, platforms to use, methods of execution, and devices for analysis.
While algorithmic trading is largely uncharted territory for most retail traders, this recent proliferation of advanced platforms and technology have made it possible for practically anyone to create an account and trade algorithmically from their living room. Expertise in data science, quantitative mathematics or even programming is not necessary in order to take advantage of the benefits and features of algo trading.
Why Algorithmic Trading?
An algorithm is a set of rules to be followed to calculate the solution to a particular problem. Algorithmic trading, also known as algo trading/quant trading/systematic trading, involves using a program to execute trades automatically. Using a trading algorithm allows a trader to avoid the psychological struggle many discretionary traders face. In addition traders can add complexity and customization to their strategy, all while saving time compared to manual point-and-click trading. There are many platforms and venues an individual can choose to trade in a more efficient and systematic way, regardless of programming skills.
So how does it work? An algorithm is programmed to look for signals, generally fundamental or technical. An example of a fundamental signal would be a change in the valuation of a currency, while a technical signal may occur when the fast moving average of the price of an asset crosses over its slow moving average. The algo recognizes this signal and makes a decision to buy or sell without any direct involvement from a human.
Traders of all asset classes and skill levels have one struggle in common—maintaining mental stability in times of uncertainty. Humans are prone to making irrational decisions when faced with stressful situations, and stressful situations occur often when trading due to sudden political events or market movements. To quote Economist John Maynard Keynes, "The market can remain irrational longer than you can remain solvent".
How can we protect ourselves from making psychological mistakes due to impulsive thinking?
By using an algo, traders can maintain discipline by removing the psychological temptations that arise when manually trading. The instrument, trade size, appropriate take profit/stop loss and the trading signal are created by the trader, while the algo continuously performs calculations on incoming prices waiting until a signal is identified. While a manual trader runs the risk of making a psychological mistake like placing an order due to fear of missing out or closing a trade before the desired take profit, an algo uses a mathematical formula to calculate each and every trade.
From planning your trading idea, analyzing charts, waiting for the entry and monitoring the exit, manual trading is exceedingly time consuming. Setting aside several hours per day for trading is not necessarily realistic for most individuals with a full-time job. Setting up an algo allows a trader to sit back and relax while leaving the algo running.
An algo can identify a pattern much more quickly and efficiently than a human looking at the same data because a computer is able to execute several computationally complex processes at once, while the human brain is limited on the amount of information it can digest at once.