How Algorithmic Trading Work

algorithm trading

Making decisions can be quite a challenge, though having the benefit of a mathematical calculation can make the entire process so much easier. In trading, the use of algorithms can help a trader make a significant amount of profit, as algorithms are able to make decisions. In essence, the algorithms are mathematical computations that are used for the purpose of decision making. They take in a large number of data sets, then with advanced mathematics are able to identify a range of patterns. From these patterns, they then go ahead and make predictions which they base on a number of probabilities.

You would be amazed by the number of traders who use algorithms to get ahead when they are trading. It is estimated that 75% of all trades are actually carried out using algorithms, while the balance is done directly by human beings. The reason is simple, and it comes down to performance. Large corporations and investment companies make use of complex algorithms because they can afford the skills and additional resources to power them. Individuals tend to use simpler algorithms due to access, and the fact that they have limited technological know how. So how exactly does algorithmic trading work? Here are several ways: –

  • The can handle more information, at faster speeds – There are certain tasks that algorithmic trading systems can execute. To begin with, they can look at information from millions of financial instruments, comparing prices and metrics. What can be achieved within minutes would take a considerably longer amount of time if an individual was trying to achieve this on their own.
  • Risk Management – The decisions that are made using algorithms are well calculated which allows for risk to be managed. When one can determine the risk, it becomes possible to bring down overall losses, as well as bring up high profits. This comes down to putting in stop loss controls. What these do is they are able to automatically liquidate a chosen position, if the algorithm has been programmed to lose more than a certain percentage.
  • No Emotion – A computer is able to process data and base all the information produced on the facts. This takes out all the information that could cloud judgement. Some of the emotional decisions that traders make is choosing to purchase stock when prices are going up, thus spending more, or to sell of their stocks when the prices are coming down. This may not be in line with the market prediction, which an algorithm could easily pick up on.

As you decide which algorithmic trading system or strategy that you want to use, you should consider how automated you want the process to be. There are those processes which are fully automated, and are also referred to as the black box. The process for making any decision comes from the code within the system. The more human intervention is done, the higher the level of discretionary trading.

As a trader, you need to ensure that you set the right limits to give you the results that you are looking for. Furthermore, the system needs to be tested as well to ensure that it performs as expected. When you are looking into algorithmic trading, you will find that you are able to make money in your spare time and with minimal effort. In addition, with the right strategy, the entire process will be totally fool proof. As the process can be a little complex, it is recommended that the trader has some technical or programming knowledge, to know the best software to use for quick results.