Algorithmic trading is a type of trading that involves the use of a computer program to place and close trades. Also known as algo-trading, black-box trading, or automated trading, this type of trade automates the trading process by utilizing a set of instructions. Theoretically, algorithmic trading can generate profits at a frequency and speed that is impossible for a human trader.
How Algorithmic Trading Works
The computer software follows a set of instructions based on price, timing, quantity, or mathematical model to determine when to open and close a trade. In addition to creating profit opportunities for the trader, back-box trading renders the markets more liquid. It also makes trading more systematic by eliminating the impact that human psychology or emotions have on trading activities.
In a real-world situation, you may follow the criteria of buying 100 shares when its 100-day moving average goes about the 300-day moving average. You may also sell shares of the same stock when its 100-day moving average goes below the 300-day moving average. With platform for investors, the computer program will monitor the stock price and automatically place buy or sell orders when the conditions above are met. You no longer had to manually monitor live prices or graphs to place orders, as the entire process will be automated.
Benefits of Algorithmic Trading
- Trades are executed at the best possible price
- Trades are instant and timed correctly to avoid significant price changes
- Placement of trade order is instant and accurate
- Reduced transaction cots
- Reduced risk of manual errors when placing trades
- Simultaneous automated checks based on multiple market conditions
- Reduced human errors by traders based on psychological and emotional factors
- Possibility of backtesting using available real-time and historical data to see the viability of a trading strategy
Drawbacks of Algorithmic Trading
Despite the many advantages of automating the trading process, the algorithmic trading method is also subject to limitations. The major drawback of using this method is the possibility of missing out on trades. Since the computer program relies on a set of rules, it may miss potentially profitable opportunities when the set conditions are not met.
The computer stocks trading program cannot identify any trading opportunities that it was not programmed for. You can mitigate this limitation by increasing the number of indicators. Although you cannot add every condition that you want to be met, doing this will to some extent minimize the limitations of the software.