Basics of Algorithmic Trading: How to start Algo Trading
A rapidly-changing technological environment has brought fascinating changes to the world of finance. Algorithmic trading or ‘Algo trading’ has endowed traders with new skills that provide a competitive edge.
What is Algorithmic Trading?
Algo trading is a trading strategy that involves using coded programs to identify and execute large trades in the market. It operates automatically based on the code that has been created. The code can be based on price, volume, timing or other mathematical and quantitative formulae. When the requirements based on the code are met, the algorithm automatically executes the trade without any human intervention.
Since Algo trading works on pre-decided conditions, getting the coding right is essential. That means you have to back-test your strategy on past data before implementing it in the real world. Once you have tested it out, you can create entry or exit trading signals that will be executed automatically when the conditions are met. Algo trading can be programmed to be positional, intraday-based, or used for high-frequency trades. For example, an Algo trading example could be:
- Buy 1 lakh shares when 14 days moving average price crosses 200 DMA (Daily Moving Average)
- Sell 1 lakh shares when 14 days moving average price goes below 200 DMA
Additional Read: Margin trading: An overview
Advantages of Algorithmic Trading
Speed is the biggest advantage of algorithmic trading. A computer-coded program can execute orders much faster than humans. It also eliminates human bias and reduces the number of trading errors, as long as the code is correct.
- Another advantage of Algo trading is that high-volume trades can be executed at fractional speeds across the markets. That also reduces the overall transaction costs. It can effectively capture arbitrage opportunities. While retail investors can use Algo trading to improve their trading strategy, institutional investors often use it to enhance returns. Algo trading also has various types of risk. It could create a huge loss in a volatile market. It can also amplify the systematic risk as most markets are interlinked and impact of one market can quickly be transferred to other markets.
Algorithmic Trading in India
The Securities and Exchange Board of India allowed Algo trading in 2008. Initially, it was restricted to institutional investors like mutual funds, hedge funds, insurance companies etc., but its growing popularity made the retail community adapt. Many broker and fintech firms offer Application Programming Interface (API) where users code their strategy or choose from the existing strategy. As per the NIFM report on Algo trading, which was published in 2018, 50% of the client trade are Algo trades, while in the case of proprietary trading, Algo contributes around 40%. In the developed markets, around 80% of the trades come from Algo.
Recently SEBI raised concerns on Algo trading. As per the present scenario, the exchange approves the Algo submitted by the brokers but doesn't control where individuals create their own using the brokers' API. SEBI has suggested that all orders routed through API will be considered Algo trades. All API involved in Algo trading will be allocated a unique Algo ID and this has to be approved by the stock exchange. Brokers also need to put a proper mechanism to control unauthorized use, alteration in the Algo etc.
As per SEBI, this unapproved Algo poses a risk to the market as these can be misused to manipulate the markets.
How to Start Algo Trading?
As a retail investor, you can begin Algo trading in the following manner:
1. Understand the Market
The first step to any kind of trading is to understand the market. Before you jump into Algo trading, get an in-depth understanding of the instrument or market you can trade-in so that you can come up with a hypothesis to base your trades on.
2. Learn to Code
If you don’t know how to code, you can pick up some coding languages such as Python and create an algorithm that works for you or get it coded by experts.
3. Back-test Your Strategy
Before you go live with your algorithm, you must test it out first. Get good quality historical data from reputed sources and back-test your strategy. You can also use third-party back-testing software to confirm whether your algorithms work. Depending on whether or not they work, you can tweak your code.
4. Choose the Right Platform
As important as your code is, it is also essential that you choose the right broker and platform to execute your trades. Pick a broker who supports your algorithm and provides various tools you can use to optimise your trading strategy.
5. Go Live
Once you are confident with your algorithm, the next step is to take it to live! Monitor its functioning in the market and keep an eye on how it works in the real world. Sometimes, your algorithm doesn’t work the way you want it to. You may then have to re-do it from scratch or tweak as per your requirement.
6. Keep Evolving
If your first strategy fails, that doesn’t mean you need to give up on Algo trading. Continue to experiment with codes and see what works best.
If you don’t have the time or skills to come up with your own algorithm, there are plenty of Algo software in the market that you can purchase that will do the job for you. Do your research, back-test the strategies and choose one that fits your requirements.
Additional Read: Making Profits with Intraday Trading
If you are a seasoned traditional investor, then experimenting with Algo trading can take your trading strategy to the next level. You can take advantage of fleeting trading opportunities which you would have otherwise missed out on. Algo trading can make you a quick, efficient and successful trader.
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