The science of automated trading is called algorithmic trading.
It is also known as algo-trading or black-box trading.
In this process, computer programs define the direction of trade.
The fundamental principle driving this trade is speed and frequency.
The profit prospect is entrenched in the pace and the frequency in which trade is conducted.
But this is speed and frequency that are impossible for humans to match.
That is precisely why this kind of trading has gained popularity as computers take on a significant role in trading.
They are based on timing, price, or quantity.
For that matter, it can comprise any other mathematical model too.
Along with a higher profit prospect, algorithmic trading makes markets relatively liquid.
This indirectly also brings in a better and higher degree of the system in place.
Trading does not pick up in terms of just volume; it also cuts out the human element more often.
So trading predominantly becomes mechanical and systematic.
The criteria of profit gradually shift to the efficiency of the mechanical formula.
Fear and greed increasingly become the less important triggers for trade.
Computer programs are created in a way that they monitor the stock price and place trading calls.
You don’t have to keep watching the price for hours now.
Algorithmic trading has put the whole process on auto-pilot mode.
You are no longer feeding orders manually.
Everything is pre-programmed and timed ahead.
The algorithmic system identifies the trading opportunity and takes a call.
That is what the primary backbone of a meaningful trade becomes.
It is no longer a discretionary opportunity.
The program will execute the trade at specific price points as decided.
This brings in the classic sense of discipline and uniformity in trade.
Does Algorithmic Trading Work?
One of the most fundamental questions that many ask at this juncture is, does this technique work?
But then, this is a tricky question.
That is because this concept covers a wide range of possibilities and theories.
Some will work and some will not.
More importantly, some methods may be profitable for a few but not so much for others.
Also, a formula can stop being profitable beyond a certain point.
So in many ways, algorithmic trading is quite similar to systematic trading.
But there is no foolproof formula and several other conditions impact the overall success rate.
But broadly it is again a theory that cuts out emotion and lets formulas rule.
A lot of the success aspect is directly proportional to the trader’s approach.
But algorithmic trading is not predominantly dependent on technical analysis alone.
It can also be trend-following, depend on counter-trend or can even be based on the pattern.
But there is one thing sure, the buy-sell points have to be clear.
There is no scope for any ambiguity there.
That is what outlines the broad essence of any strategy that is implemented in this case.
The signal for buying and selling stocks is valuation based and may be derived from a number of metrics.
But remember that backtesting a formula or a method is as important as developing it.
The overall success ratio is directly dependent on that.
That will give you real-time results before you commit any money in the market.
It will also give you a proper sense of the risk involved and the degree of control you require.
While minute to minute monitoring is not required, your analysis has to be foolproof.
Because the success of the trading formula is based on it.
Momentum Investing As An Algorithmic Trading Strategy
You will notice a plethora of algorithmic trading strategies.
Different kinds of traders have a different approach.
But there are some strategies that have undeniable charm and a timeless appeal.
They are popular not just because of their success rate but also the relative ease of implementation.
In fact, that also acts as a catalyst towards its popularity.
The momentum investing strategies fall in this list.
As the name indicates, this strategy is deeply dependent on momentum in the market.
So in this case, the traders are on a lookout for a market trend that indicates significant movement.
The market does not just get swayed by a momentum, but volumes also back this.
That is what gives credence and meaning to the overall momentum seen.
A variety of algorithmic trading systems can be applied to this momentum.
It can be either extremely simple or may be a bit complicated.
The simplest of the momentum strategies may involve investing in the top 5 stocks with consistent performance over 12 months.
Now you can add a pinch of complication by blending the time element too.
Investors may also look out to rebalance momentum.
The time duration, however, can differ.
It can be anywhere between weekly to monthly, even quarterly in some cases and yearly in a few.
The overall trading objective has to be married with the momentum.
That will yield the ultimate results and key profit objective that you may have in mind.
Let me use an example, an algo trader will be following a specific trend in the market, X.
Now as per the analysis, the market slips.
Now you can use the stats from the trend to determine whether it is headed to.
Your next move then gets adjusted accordingly.
This is another common algorithmic trading strategy.
Like momentum trading, this too proceeds as per a set formula and yields comfortable results.
The term arbitrage generally means taking advantage of a difference in pricing.
These are primarily quantitatively driven strategies and yield pointed results.
The core point is to exploit the price difference across a range of financial instruments.
If we get an information that X Company will be bought by Y Company, the share prices also affected.
The new of acquisition can drive the price higher.
So temporarily a pricing inefficiency is seen.
This may be part of a broad trend or may not be.
But there is surely an event-driven pricing uptrend.
Normally any such news like a takeover, acquisition, merger, bankruptcy triggers this type of price movement.
As a result, you can use this temporary difference as an arbitrage strategy.
Normally this type of pricing does not have a huge implication on the overall market.
As a result, they fit very well in the overall algorithmic trading strategies.
But remember the window of opportunity is very short.
Many trades in quick succession are what creates the best profit opportunities.
Incidentally, pace and volume are also the fundamentals of algorithmic trading.
An automated machine can keep track of these changes way more closely than any human intervention.
The advantage here is that you get the advantage of the smallest price change.
While individually a difference of a few cents may not be significant, it can be huge on high volume trade.
Often this arbitrage price becomes the core profit percentage for the specific trade.
Traders can lock in higher than usual profits if they can execute it appropriately.
Faultless and quick execution holds the key to success in this formula.
This is what makes it profitable.
Algorithmic trading essentially means that you have to exploit a specific price point.
The trigger for this is never any one aspect though.
A given situation can have multiple triggers or depending on the results you need, the triggers may alter.
This is exactly the reason that these seasonal strategies fit so well in the overall scheme of things.
Algorithmic trading heroes the benefits of taking advantage of a quick change in pricing and booking profit.
So there are some strategies that can work during a specific period in the year.
For example, it is common knowledge that the returns towards the end of the year are much higher.
The warm months deliver better returns than the colder ones.
Most times, it is also an openly accepted truth that September offers distinctly lower returns.
So there are some traders who may choose to sell during December.
The stock price trend is very different in the Holiday season.
Moreover, they may also get some amount of tax leniency.
Most importantly this seasonality element is not restricted to any one market.
So you can use algorithmic trading to take advantage of the seasonal changes in pricing.
In many ways, this is again one of those strategies that depend on arbitrage.
So it can help investors optimize their long-term positions using this strategy.
It is a straightforward approach that openly acknowledges the pricing difference and takes advantage of that.
Needless to mention that this strategy goes a long way in reducing the risk too.
Instead, the risk becomes significantly controlled and manageable too.
Traders who execute these seasonal price changes factor the risk in their formula.
That way it offers a more constructive scope for continued profitability.
But timing and pace of execution are the key factors to watch out for here.
When you look for popular algorithmic trading strategies, this one is another popular option.
The term mean refers to an average.
In this case, mean revision refers to drawing the average of a high and low price.
This could be calculated from a temporary high and low prices.
This may refer to an arbitrary period with no pre-determined formula to fix this.
Normally the algorithmic trading formula uses the relative movement in the security to compute this.
So the potential profit too is calculated using the same formula.
It is expected to move either away or towards the mean depending on the expectation.
The fundamental premise of this approach is based on some inherent price trends in securities.
On an average, it is seen that many asset prices move back to the mean zone after extended oversold or overbought conditions.
So when you are using this strategy, the core idea is prices will revert to the mean at some levels.
So the trader does not worry about the oversold levels or the overbought condition.
The Algorithmic trading strategy is embedded in the concept of patience here.
Investors need to wait for sanity to return and prices to move back to mean levels.
This is how it is called the mean reversion strategy.
Scalping is another commonly used algorithmic trading strategy.
This again is a type of arbitrage where you see the scalpers benefiting from the difference between the bid and ask price.
It is also known as the bid-ask spread.
But the beauty of algorithmic trading is that the scalper is not happy with just one trade.
There is repeated scalping at very short intervals.
As a result, you have a number of trades in a very short time.
Moreover, all the trade is created with the concept of deriving the maximum possible advantage from the price difference.
These individual trades often take place within minutes of each other.
That is how you can optimize the profit potential using the algorithmic formulas.
While you are undertaking scalping strategies, you can also look at transaction cost factors too.
They too offer some reasonable scalping opportunity, especially across markets and asset classes.
The broad idea remains simple.
Don’t let a single change in asset pricing go without yielding advantage to you.
But one important factor in this is you have to take some very quick and form decision.
That alone will help deliver the desired results every time.
Factors Driving Stock Price
As the name indicates, the stock price movement is determined by a series of factors.
The trader often tracks the varieties of factors and looks at drawing a meaningful profit from the price difference.
That, of course, is planned out through executing appropriate algorithmic trading strategies.
The factors have a wide range of possibility and potential.
It can be any factor that drives up the price or pushes it down.
As a result, you may see momentum, earnings, beta trends and cash flow issue impacting prices.
As a result, you can use these factors individually or in combination with other dynamic strategies.
These factors can individually affect allocation to a large extent.
Normally historical data is taken as a crucial benchmark in this case.
The price momentum or movement is calculated on the basis of that.
The algorithmic trading strategy here looks at how best the individual factors ascertain a better pricing power to the overall stock price.
The objective remains same across a gamut of algorithmic trading strategies.
You have to maximize profits through quick and plenty of trades in a particular time zone.
That is what makes it a profitable opportunity across asset classes.
Benefits of Algorithmic Trading Strategies
There are some distinct advantages of incorporating algorithmic trading strategies to widen your base and portfolio profit.
This is a completely automated trading opportunity.
As a result, trade proceeds on its own as when the pre-determined price points.
So it enables fast and effective trading.
Investors do not have to bear the brunt of their indecision in any way.
The computer does the thinking and execution for the trader.
All you have to do is install the appropriate program that will yield the desired result.
2. Fast Paced
The automation also goes a long way in making these trades fast and accurate.
There is a much higher instance of order placements at any given point.
This raises the chances of the order getting executed at your desired rate.
That surely enhances the overall profit potential.
3. Lower Transaction Expense
This kind of trade also reduces the total transaction cost involved.
By trading off the real-time market, they can save the cost of the transaction.
At the same time, they also give you the benefit of delayed execution cost.
As a result, the strategy also regulates the trading volume in this region.
When the stock moves higher, the targeted participation increases.
When the prices move down, the participation decreases too.
Needless to mention, that has an adverse effect on the overall stock price and sentiment.
Therefore, if you are looking safe and steady gains, algorithmic trading strategies may be ideal.
They cut out human emotion and bring in a lot of pace and volume based surge in your prices.
It often helps the market too to identify larger chunks of price movement that you can profit from.
But at the end, remember that algorithmic trading is a profit-oriented program.
This profit is, however, subject to many factors.
So backtesting the authenticity of the program is crucial before you commit cash to algorithmic trading strategies.