What Is Algo Trading - Meaning, Benefits and Steps To Invest

The financial industry has undergone a change, thanks to technology. One of these technological changes, algorithmic trading or algo trading, has armed traders with new skills that provide them a competitive edge. Here is what algo trading means and the pros and cons it entails.

What Is Algo Trading?

Algo trading is a type of trading that involves locating and carrying out significant trades in the market using coded programmes. The computer uses the created code which can be based on price, time or any other factor, through a mathematical formula.

The Securities and Exchange Board of India (Sebi) first permitted algo trading in 2008. Back then, it was restricted to institutional investors such as mutual funds, hedge funds and insurance companies.

As it gained popularity, eventually retail traders also started using it. Many fintech and broker companies provide Application Programming Interfaces (APIs) that let customers create their own strategies or select from pre-existing ones. For example, one of the strategies could be “purchase 1 lakh shares when the 200 DMA (daily moving average) crosses the 14-day moving average” or “sell 100,000 shares if the 14-day moving average falls below the 200-day moving average”.
The algorithm performs the deal without any assistance from a human once the conditions based on the code are satisfied. It is essential to get the code correct as algo trading works on that pre-decided formula on which the code is based.

How to Start Algo Trading?

Retail investors can start Algo trading by following these steps:

1. Understand The Market:

The first step in any type of trading is recognizing the market. Before you begin algo trading, gain a thorough understanding of the instrument or market in which you intend to trade so that you can develop a hypothesis and understand on which basis you have to trade.

2. Learn To Code:

Coding is one of the essential requirements in algo trading. If you don’t have a coding background, you can learn some coding languages like Python and come up with an algorithm that works for you. Otherwise, you can hire professionals to write it for you.

3. Back-test Your Strategy:

You must test your algorithm before putting it into use. A run-through is a must. Test your plan with high-quality historical data from reliable sources. In order to verify that your algorithms are effective, you can also employ third-party back-testing tools. You can modify your code depending on whether or not they function.

4. Choose The Right Platform:

Your choice of broker and trading platform is as crucial as the quality of your code when it comes to trading. Select a broker that offers a variety of tools you may use to optimise your trading strategy and supports your algorithm.

5. Go Live:

The next step is to publish your algorithm once you are sure it works. Keep an eye on how it performs and observe how it functions on the market. It's possible that your algorithm won't always perform as you expect. Then, based on your requirements, you might need to start afresh or make modifications.

6. Keep Evolving:

You don't have to abandon algo trading if your initial strategy fails. Test various codes to see which ones are more effective.

Pros And Cons Of Algo Trading

Pros:

One of the biggest advantages of algo trading is its fast speed. It gives you quick trade results. It also eliminates human bias and reduces the number of trading errors. Even high-volume trades can be executed at fractional speed through this.

It is capable of seizing arbitrage chances successfully. While institutional investors frequently utilise algorithmic trading to increase returns, retail investors can use it to sharpen their trading strategies.

Cons:

Algo trading comes with huge risks. In a choppy market, it may result in significant loss. As most markets are interconnected and the effects of one market can be quickly transferred to others, it can also increase the systemic risk.

Don’t forget to conduct your own thorough research, back-tests tactics, and then select the best code that meets your needs. There are tonnes of algo software available in the markets that you may buy if you don’t have the time or expertise in coding.

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