When do Algorithmic Strategies Work?

May 10, 2014

- By Asad Dossani, Author, The Lucrative Derivative Report

Asad Dossani
Algorithmic trading involves trading based on a specific set of rules that are predetermined. The rules are optimized by backtesting trading strategies on historical data. Technical analysis is very similar, in that it also generates trading signals based on past price behavior. I have spent a few articles talking about algorithmic trading, as I am working on building own trading algorithm and would like to share some insights with you along the way.

The key to understanding when algorithmic trading strategies work is to understand what its limitations are. Algorithmic strategies use historical data to predict future prices. Future prices depend on two things. Future prices depend on what has happened in the past, and they also depend on what news occurs in the future.

When prices move due to news occurring in the future, this is difficult to capture with an algorithmic strategy. For example, depending on the outcome of the election in next week, the market could move either up or down. And the markets movement will depend on the election result. This type of movement is impossible to capture with an algorithmic trading strategy. This is because the past price behavior is not useful for predicting the result of the election, and so past price behavior won't predict what happens to markets when the election result is announced.

To sum it up, whenever unpredictable fundamental news is driving markets, algorithmic strategies will not work well. This gives us the key to understanding when algorithmic strategies do work well. Whenever there is little or no news, markets can still move around considerably. These movements can't be explained with fundamentals, and this is where algorithms can be very useful.

Many market moves that occur in the absence of fundamental news have repeated patterns that can be exploited. And this is what algorithmic trading strategies attempt to do. Most of the time, there isn't major news that moves markets. There is plenty of speculation over future news, but actual significant events only occur occasionally.

Algorithmic strategies work best when market moves are not driven by fundamentals. Algorithmic strategies work poorly when markets move due to large news events such as election results. Understanding this insight is necessary to creating successful algorithmic trading strategies.

We are asking the following question in the Equitymaster Club Forum: "How do you trade major news events, such as election results?" We invite you to please login 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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2 Responses to "When do Algorithmic Strategies Work?"

ADA

May 14, 2014

Algorithmic Trading works 24/7

Like (1)

pramod

May 12, 2014

stock market is like IPL matches all internally fixed.

Like (1)
  
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