How is algorithmic trading beneficial? Must you be an expert programmer?
Today, we see this term algorithmic trading (algo-trading for short) very often in the news, either about disrupting how the markets function, or making entire departments in financial institutions obsolete.
Automated trading is defined as the process of using a computer programmed to follow a defined set of instructions for opening and closing trades in order to generate profits according to a trading strategy as devised by the human trader. In simple terms, algorithmic trading helps to execute trades when conditions are met as instructed by the human traders.
As algorithmic trading is implemented based on a human’s trading strategy, it will only successfully make profits if the trading strategy is a winning strategy. Hence, algorithmic trading should only be explored with if you have a winning trading strategy already.
So, what if we don’t even have a profitable trading strategy to begin with? After all, automating a losing trading strategy will just make you lose more at a faster and consistent rate! That is just suicidal. Do not fret, you can still ride the wave of this automation phenomenon. The solution here is to use an automated trading system devised by another trader. If designed properly, these trading systems will make consistent profits over long periods of time. We will be talking about how to differentiate good trading systems from the rest in another article.
Now, let’s discuss about the benefits of using algorithmic trading systems and then you will understand why it is getting very popular today.
Advantages of using Algorithmic Trading Systems
1) Executes trades void of emotions:
- As human beings, we are always plagued by the emotions of Greed and Fear while trading. These two emotions are enough to cause us to alter our trading strategies that we have planned from the beginning and this might cause us profitable trades each time. By surrendering your trading to a computer you can avoid making emotionally-driven mistakes. A computer doesn’t think, get angry or sad, it just follows orders and only executes when the rules and criteria of the strategy it is following are met. This is likely to save you from lots of bad trading decisions over time.
2) Ability to backtest:
- Backtesting applies trading rules to historical market data to determine the viability of the idea. When designing a system for automated trading, all rules need to be absolute, with no room for interpretation (the computer cannot make guesses — it has to be told exactly what to do). Traders can take these precise sets of rules and test them on historical data before risking money in live trading. Careful backtesting allows traders to evaluate and fine-tune a trading idea, and to determine the system’s expectancy — the average amount that a trader can expect to win (or lose) per unit of risk.
3) Executing trades 24/7 without needing to rest:
- Cryptocurrency and forex markets do not sleep. This makes is rather difficult for retail traders to monitor the market efficiently and many trade opportunities are missed while the trader is at work, asleep or away from their internet device. Automated trading solves this problem as the computer is always on and readily monitors the markets round the clock.
Now that we have talked about the benefits of using automated trading systems, let’s now discuss the drawbacks of using them.
Disadvantages of using Algorithmic Trading Systems
1) Mechanical Failures:
- Depending on the trading platform, a trade order could reside on a computer — and not a server. What that means is that if an Internet connection is lost, an order might not be sent to the market. There could also be a discrepancy between the “theoretical trades” generated by the strategy and the order entry platform component that turns them into real trades. Most traders should expect a learning curve when using automated trading systems, and it is generally a good idea to start with small trade sizes while the process is refined.
- Automated trading systems do require slight monitoring due to the potential for mechanical failures, such as connectivity issues, power losses or computer crashes, and to system quirks.
- Backtesting techniques can create systems that look great on paper and perform terribly in a live market. Over-optimization refers to excessive curve-fitting that produces a trading plan that is unreliable in live trading (over-fitting). It is possible, for example, to tweak a strategy to achieve exceptional results on the historical data on which it was tested. This over-optimization creates systems that look good on paper only.
Now you know both the advantages and disadvantages of using automated trading systems. It is important NOT to merely look at the profits/earnings of a trading system. Make sure to do your homework on all the relevant factors before putting your money with the systems.