The Rise of Algorithmic Trading

Mar 14, 2014

- By Asad Dossani, Author, The Lucrative Derivative Report

Asad Dossani
One of the major trends to affect financial markets in recent years is the rise of algorithmic trading. Algorithmic trading is the use of a pre-defined set of rules or instructions to make trades in markets. Typically, algorithms are created by testing out trading ideas on historical data. In some cases, especially in high frequency trading, trades are automatically executed by a computer.

Algorithms almost always use historical data to come up with and to test out trade ideas. One example of an algorithm is a technical trading rule. For example, we could create a trading rule that says buy when the 5 day moving average crosses above the 20 day moving average. The algorithm would also specify under what conditions to exit the trade, i.e. a stop loss and a profit target.

Algorithmic trading is not limited to technical analysis. Fundamentally based value investing algorithms are also heavily used. For example, one could create an algorithm that says we should buy stocks with P/E ratios less than 5, or P/B ratios less than 1. This type of algorithm is the basis for Benjamin Graham's value investing philosophy.

The rise of algorithmic trading is due to two factors. The first factor is the increased availability of historical data. Today, we have a far more historical market data than we ever have. We can even access tick by tick historical data for any asset. The second factor is the increased computing power we can use to analyze this data. Computers have become cheaper and more powerful over time, and this has allowed market participants to make increased use of algorithms.

One of the main advantages of algorithmic trading is that human emotion is taken out of the equation. Once a trading rule is put in place, there is no more role for humans to intervene in the trade. This prevents many behavioral problems that investors face, such as holding on to losses too long, or selling winners too early. Another advantage of algorithmic trading is that trade ideas can be properly tested out, and only good trade ideas actually get used.

Algorithmic trading has its disadvantages too. One of these is that algorithms assume that past market behavior will prevail in the future, and this is not always to case. A strategy that was profitable in the past is not necessarily going to be profitable in the future. Algorithmic trading has its pros and cons, but one key fact is that it is here to stay, and is getting more popular over time. Algorithmic trading also presents new opportunities for retail investors to diversify their portfolios and improve their returns.

In the Equitymaster club forum, we are asking the question, "Do you use algorithms to trade? If not, are you interested in doing so?" We encourage you to please log in and post your views.

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is a financial analyst and columnist. He actively trades his own and others' funds, investing primarily in currency, commodity, and stock index derivative products. Prior to this, he worked at Deutsche Bank as an analyst in the FX derivatives team. He is a graduate of the London School of Economics. Asad is a keen observer of macroeconomic trends and their effects on global financial markets. He is deeply passionate about educating investors, and encouraging individuals to take part in and profit from financial markets. To put it colloquially, he wishes to take Wall Street products and turn them into Main Street profits!

Disclaimer: The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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8 Responses to "The Rise of Algorithmic Trading"

VEERESH

May 11, 2014

Algorithm trading is good but in which market conditions & for which type of stocks pl provide its specific use.

Like (1)

Hari Gopal Sharma

Mar 19, 2014

As a general investor ,I neither have time nor inclination and to tell you frankly the required expertise to work with this Technic.
This seems to be a via media of pure value investing and emotional participation in market.

Like (1)

Jugal kishor

Mar 18, 2014

I am very much intersted in Algo Trading but please guide me How to go for it ?

Like (1)

VVIJAYARAGHAVAN

Mar 17, 2014

doing trading with technical charts

Like (1)

mukul kumar

Mar 16, 2014

y am interested algo trading but do bot how to go about it

Like (1)

DC Gupta

Mar 16, 2014

Yes, I would like to use algorithmic trading.

Like (1)

malay

Mar 16, 2014

Would be interested in finding more and how can execution be done and what toold are available to facilitate.

Like (1)

Ravi Shankar

Mar 16, 2014

I experienced a massive hit with ING Vysya where one of their product portfolio's was structured according to this method. The Company put the onus back on the investor, stating that it was with full knowledge that the investor signed up for it...It is like a ROBOT operating in the market. Chances that one will experience success are slim, as there is no human thinking involved and this acts as a huge negative as there is simply no substitute for the human mind's capacity to analyze, configure and invest. Particularly, with the changing dynamics of the Indian scenario and the global influences. A BIG THUMBS DOWN FOR THIS TECHNIQUE - WHAT WILL WORK IS A COMBINATION OF THE TWO - USE THE TECHNIQUE TO SHORTLIST STOCKS THAT ARE LIKELY TO PERFORM AND ANALYZE THESE STOCKS, KEEPING TRENDS AND CIRCUMSTANCES IN MIND.

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