What is Algorithmic Trading?

Last Updated on September 27, 2023 by BFSLTeam BFSLTeam

As we become more technologically advanced, computers are taking over most of the jobs we used to do. Be it your mobile phones or those robots working in a factory, programs running on algorithms are everywhere! You can even see the impact of this in the stock market also. With more than 50% of the NSE’s liquidity coming in from automated trading algorithms, India’s market share of algorithmic trading is increasing rapidly. In other words, when you put on a trade, there’s a 50% chance that a computer will take up the other side of your trade.

A reason for this fast adoption is that this approach to trading has made it very easy for traders to execute trades. Algorithmic trading has eliminated emotions in trade execution. But let’s not get ahead of ourselves. Firstly, let us take a look at what Algo trading means.

What is algorithmic trading?

Algorithmic trading means automating a new trading idea or an existing trading strategy by using an algorithm.

Big fund houses mostly do algorithmic trading to punch in orders at a huge scale that would have been humanly impossible to execute. Algorithms can execute orders like these within a very short period.

Now, let us take an example to understand how Algo trading works.

Mr. A, an Algo trader, wants to trade with a different strategy now. Let us assume that he wants to take a trade every time the RSI goes above 60 levels. So rather than manually opening his account, feeding in order details, and clicking on the execute button, Mr. A creates an algorithm based on instructions that will automatically execute a long trade whenever the RSI of a stock rises above 60. Of course, Mr. A will also have to mention details like quantities to buy, stop loss, etc. This algorithm will now automatically execute trade whenever similar instructions are met in any stock.

Additional Read: Scalping Trading

Strategies of Algorithmic trading

You can automate any trading strategy by giving sufficient instructions. Here are some of the most commonly used algorithmic trading strategies.

Arbitrage strategy

In arbitrage trading strategy, algorithms analyze stock prices from different stock exchanges. It then buys a stock trading at a lower price from a specific exchange and sells it into a different stock exchange where the price of the same stock is relatively higher. This strategy aims to profit from price differences of the same stock in different stock exchanges. This process of buying and selling is done within seconds!

Trend-following strategy

This is one of the most commonly used and simple Algo trading strategies adopted by most investors and traders. What makes this simple is that the trades in this strategy are executed by following the trend and the market’s momentum. Trend-following tools such as moving averages, trendlines, and chart patterns are used to identify an entry and exit in the trade. When the algorithm meets with a proper set of instructions required for this strategy, the strategy gets executed automatically.

Index fund rebalancing strategy

Index funds have to adjust frequently to match their underlying asset’s performance. This strategy aims to take advantage of this minor opening and grab the opportunity by taking a trade for making a profit as low as .20 to .80 basis points.

These orders are executed in microseconds which is why they are humanly impossible to execute.

Mean reversion strategy

“Mean” means the average price of a stock. It is said that the underlying fluctuation in a stock is temporary, and the stock will always revert to its mean. In this strategy, algorithms define a specific range for a stock. And similarly, they buy and sell orders as the price of the stock gets in or out of the defined range.

Benefits of Algorithmic trading

Here are some of the reasons why algorithmic trading is being adopted so quickly by many investors and traders.

• Algorithmic trading executes a trade at a very high speed and a precise price.

• Issues like slippage are not a problem when it comes to algo trading.

• It helps big fund houses to punch in huge orders without significantly affecting the market price, which can otherwise result in huge losses for retail traders.

Frequently asked questions on Algorithmic trading