what-is-algorithmic-trading-the-definitive-guide

What is Algorithmic Trading? The Definitive Guide

Did you know that there’s a simple way to reduce human error in your trading? It’s called algorithmic trading, and it might just rock your world — or at the very least, your watchlist.

Algorithmic trading (also referred to as algo-trading if you want to sound cool) is a type of automated trading. It’s a mathematical approach to trading that helps you identify the strongest contenders of stocks to trade. Some programs can even execute trades for you.

Does that sound like a future that you want to be part of? Here, we’ll introduce you to algorithmic trading, including what it is, the benefits, and common approaches to this trading style.

What is Algorithmic Trading?

Algorithm + trading = algorithmic trading. But … what does that mean, exactly?

You already know what trading is, so let’s take a moment to define what an algorithm is.

According to the dictionary, an algorithm is “a set of rules for solving a problem in a finite number of steps, as for finding the greatest common divisor.”

For a real-life example of algorithm that most people will understand, think about the ads that you see pop up while you’re browsing the internet, say on Facebook.

You may have noticed that these ads often seem eerily tailored to your interests. For example, yesterday you were online shopping for ceiling fans, and suddenly all of the ads you see are for fans and pendant lights.

You have an algorithm to thank for that. The algorithm tailors the content based on what it determines is most likely to be a match for you.

In the world of trading, you can apply this algorithm magic to set up specific factors that will filter potential trades down to what will hopefully be strong and relevant picks for you.

The idea is that by automating the process you can take a lot of the guesswork out of it, and take a more systematic and calculated approach to trading.

How Algorithmic Trading Works

How might algorithmic trading actually play out for you? Basically, you apply an “if/then” situation via a stock screener, and can rest assured that the results meet certain criteria that warrant a spot on your watchlist.

First, you set your criteria. For example, if a stock’s 15-day moving average dips below the 60-day moving average, you might want to buy 100 shares. Or, you might want to sell 100 shares in the reverse scenario.

Of course, that’s just one example — it could be any number of different criteria that you have chosen.

By setting up these parameters, your computer program can monitor the stock’s price movement and these indicators so that you can keep track of potential stocks to trade, or even execute orders to buy and sell when they are met.

Benefits Of Algorithmic Trading

What’s so great about algorithmic trading? Here are some of the benefits:

  • Time-saving: Don’t work harder, work smarter. Algorithmic trading holds the promise of saving you time by cutting out some of the grunt work. It monitors criteria for you, so that you don’t have to constantly tap away at your computer, running the same indicators over and over with multiple stocks.
  • Capitalize on what’s working: As time goes on as a trader and you keep your setups in your trading journal, you may notice that you’re constantly looking for certain criteria in your trades. If you notice that certain setups tend to work better for you, you can set them up as an algorithm and continue looking for similar circumstances in the future.
  • Identify stocks you may not have noticed: If you’re manually scanning for potential stocks to trade, you can get distracted or miss things. Algorithmic trading helps put the most promising opportunities right in front of your eyes.
  • More precise timing: A computer’s timing is probably better than yours. With algorithmic trading, trades are timed to help you escape quick price changes that could affect your trade.
  • Reduced human error: As a human, you might press the wrong button when trying to execute a trade. This won’t happen with algorithmic trading since it’s all mapped out.
  • Helps you stick to the plan. One of the hardest parts about trading is keeping your emotions on an even keel. Algorithmic trading helps you take a more mathematical approach and helps you from making rash emotional decisions.

Algorithmic Trading Strategies

Curious about algorithmic trading strategies? Here are some popular ones among traders:

#1 Trend Following Strategies

One of the most common strategies traders use is to follow trends by using indicators. Some popular indicators? Moving averages, breakouts, and big price movements.

This method is understandably popular because it’s easy and doesn’t involve any complicated forecasting. Basically, you can initiate a trade when a stock meets your desired trend criteria.

Long-, Medium-, or Short-Term Moves

Another nice thing about the trend following strategy is that it can be applied to a variety of different time frames.

For example, 50- or 200-day moving averages is a common strategy for trend following in algo trading, but this can be altered based on your trading style. This means that whether you favor short term moves or longer ones, you can set up your criteria to meet your preferences.

#2 Mathematical Model Algorithmic Trading

Hooray for nerds! Mathematical model algo trading relies on tested and proven numbers-based strategies.

One example is what’s known as the delta neutral trading strategy. In case you aren’t familiar with delta, it’s a ratio that compares a security’s change in price to the price of its derivative.

With the delta neutral trading strategy, your algorithm helps you pick trades based on positions with both negative and positive deltas. The goal is to remain basically at zero or neutral, so that you have a series of checks and balances built in.

#3 Volume Weighted Average Price (VWAP)

VWAP is another popular strategy for algorithmic trading.

VWAP stands for volume weighted average price, but traders often just say “vee-whap.” This is a calculation that helps you determine the average price of a security over a period of time.

The idea is that this average can balance out peaks and valleys in price and give you an accurate view of the current price of the stock as it compares to this average line.

Often, a rising VWAP is an indication of an uptrend, where a falling VWAP is an indication of a downtrend.

This can help you pick the best entry and exit points, and can help you decide whether an aggressive or cautious approach is in order.

What is a VWAP Strategy?

In algorithmic trading, the VWAP strategy chooses trades by determining what price to execute your order at to get close to the VWAP.

It does this by taking a big order and breaking it down into smaller orders based on the historical volume.

How is VWAP Calculated?

How do you figure out the VWAP? Well, if you must, you can calculate it by adding the dollar amount for every transaction, then dividing this number by the sum of shares being traded.

However, if you’re not so inclined to do it yourself, StocksToTrade makes it easy. It’s an indicator that can be set as a line on intraday charts. By adding the VWAP indicator to the chart of a stock you’re monitoring, the equation will automatically be calculated for you.

#4 Percentage of Volume (POV) Algorithmic Trading

This is an interesting volume-based approach to algorithmic trading that is designed to not rock the boat in the market when placing larger orders.

In essence, it keeps placing smaller orders until the order is completed. The time window for trading is divided into smaller time periods, and every time the market has your desired volume participation, it’s executed.

Take Advantage of StocksToTrade Features

Looking to try out algorithmic trading for yourself? StocksToTrade makes it easy thanks to Oracle, our automated watchlist generator.

What’s Oracle?

Oracle is a generator that is based on a prediction algorithm. It is able to evaluate all US stocks and determine which ones have the most breakout potential. It does this by figuring out which ones are most likely to break out of support and resistance lines using a proprietary algorithm based on various technical factors.

With Oracle, you can quickly filter down your watchlist. It helps locate potential stocks in the pre-market hours, and then filters down the list upon the market open. This helps you get a leg up on your trading day for the potential plays that suit your style as a trader.

Conclusion

Algorithm trading is a numbers-based approach to filtering stocks that helps you approach trading in a mathematical way. Not only is it time-saving, but it takes a lot of human error out of the equation and helps you locate strong potential plays.

However, algorithm or no, there are never guarantees in the market. Algorithmic trading can help you use past data to make informed decisions about future trades, but there are too many factors and unknowns for it to be spot-on all the time. For the best results, use algorithmic trading as part of your strategy rather than relying on it entirely.

Have you ever tried algorithmic trading? We want to know about your experience. Leave a comment below!