"Bots! huh? What do they know about trading? Stock market requires insights, timing and a level of genius that only humans can have", said my friend when I asked him about his take on algorithmic trading. Could it be true? Is algorithmic trading a gimmick? Well, not quite so, in fact it’s the opposite.
84% of trades that happened in NYSE, 60% in LSE and 40% in NSE were done using algorithmic trading. From the looks of it, it seems sooner or later every trade will be done using algorithms. But why is that?
What is Algorithmic Trading?
Let’s say you have a strategy based on quantitative analysis that you developed (or stole) and it’s working well for you. Let’s assume that your strategy tells you when to buy/sell a stock and when to book profits or cut losses. This is the bare minimum a strategy should have. If yours doesn’t, boy, you’re in trouble! So when you’re sitting at your desk sipping that Earl Grey, you’re doing either of the following things at any given point –
- Looking at charts, quotes or news and trying to find a trade signal as per your strategy
- Filling in the order details when you DO find a trade signal (money time! Yay!)
- Monitoring your trades to see if they reached your target or went in the opposite direction (as they often do)
- Closing positions to either book profits or cut losses
- Rinse and repeat
This is how you look while working (on an average):
Now remember, your strategy, no matter how successful on paper, is only good as long as you stick to it. To follow your strategy religiously is a vital prerequisite for making profits in the long run. That means you don’t give in to your emotions, you don’t make approximations, you don’t prematurely book profits or cancel stop losses because you think the stock will eventually move in your direction. Let’s assume you don’t do all of those things, let’s say you follow your system like a devote catholic and you are a superhuman who has mastered his emotions like a Buddhist monk (I know you’re not even close but let’s just say you are).
Even after doing all of this (getting to the superman/monk level), you’re not done yet. There are still many factors that you need to get right before you start making actual profits from your strategy. For example, you need to continuously backtest and tweak your strategy to make sure it is relevant in these ever changing markets. Having just one strategy will expose you to various risks, to mitigate that you’ll have to diversify and use at least two different strategies. And for this, you will need to keep scanning markets for new assets to trade that will fit your strategies, etc and etc.
In short, to be successful in trading (specially quantitative) you should act like a superhuman. But we both know that the truth is different. We often make mistakes, we often do things that we’re not supposed to and we end up being sad, miserable and with less net worth.
But, what if there was a way to outsource most of this heavy and depressing work, what if someone else pulled their hair and screamed over losses, what if you just stood by (sipping martinis) knowing that your strategy is being followed properly and you will eventually make money and the only work you have to do is focus on the strategy?
Let me make that martini for you, and welcome you to the world of Algorithmic Trading. Algorithmic trading is handing over the reins to a computer. You just have to write down your strategy in a language that computer would understand and let the computer do the heavy lifting for you. All the tasks that you do in a day (mentioned above) as a trader are mechanical in nature and can be done by a machine in a much better way. Computers can scan hundreds of stocks and execute as many orders in a matter of seconds (this is used in High Frequency Trading or HFT), and the setup costs for automated desks are coming down as well. The concept of letting machines do mundane tasks while we focus on higher intelligent things is a trend that is not just in trading but everywhere else. Read: self-driving cars, smart homes, siri etc.
Benefits of Algorithmic Trading
Human Emotions = 0
Machines do not have emotions (at least not yet, good luck google!) and we can use that to our advantage. In manual trading this is a huge detriment. Fear and greed prevent us from doing what is right. Machines don’t cloud their decisions based on any external factors as they just follow what’s written in the program. When you realise that majority of trades in the market aren’t driven by emotions, it automatically puts you on a back foot making Algorithmic Trading a necessity. Your strategy truly gets a fair chance when you drop emotions out of the equation.
Accuracy + Speed = 100
Machines are accurate every single time when it comes to dealing with operational things in trading. For example, filling in the correct order details, I have found myself making silly mistakes in this department many times. I am pretty sure everyone has done this at least once in their trading life. Our inefficiency with respect to speed and accuracy can cost us huge opportunities. Even a skilled trader will take at least 10-15 secs to place an order, in the age of machine trading 10-15 secs is an eternity and the price can move significantly. This is true especially in terms of HFT trading. The computer will have placed and closed 100s of orders in that time frame.
Comfort = 1000%
Just imagine not having to go through that stressful roller-coaster ride every single day. This alone is more than enough reason for you to start learning Algorithmic Trading. After all, the stress part wasn't mentioned when they sold you trading as a profession, so why deal with it now? Trust me it is an awesome feeling.
Scalability = level 100
Given the vast amount of computing power available today, we can run multiple strategies which can scan thousands of signals for trade opportunities, all at once. This is not possible for humans by any means. Heck, we humans can’t even focus on one task for long and how can we? Damn you, 9gag!
Having said this, let me tell you some minor but important details relating to Algorithmic Trading.
Algorithmic trading is the process of using computers programmed to follow a defined set of instructions for placing a trade in order to generate profits at a speed and frequency that is impossible for a human trader. There are multiple programming languages available for this purpose, some of them are R, Python, C++ etc (click here to read why Python is the most preferred language for algorithmic traders). Whichever language you choose, you do need to make sure that your algorithm is communicated properly to the computer and covers all possible events that a market can throw. Otherwise, your computer will behave like a loose cannon. The damages in such situation can be substantial.
If you are interested in setting-up your own algo trading desk, this post will guide you through the entire set of requirements ‘Setting-Up an Algo Trading Desk’. In short, you’d need a working strategy, trading software that allows automated programs to run, programming skills to code your strategy and historical data for testing, this is apart from usual trading things like broker, licenses etc.
Algorithmic trading is the future, the only question is when do you get on board?
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