Basics of algorithmic trading
Algo-trading provides these advantages:
– Trades executed at the best possible prices
– Immediate and accurate trade arrangement positioning (thereby high likelihood of performance at desired amounts)
– Trades timed right and forthwith, to avert significant cost changes
– Reduced transaction costs (see the execution shortfall example below)
– Coincident automated tests on multiple marketplace states
– Decreased risk of manual errors in placing the trades
– Backtest the algorithm, depending on available historical and real time data
– Reduced chance of errors by human traders based on variables that are mental and emotional
Algorithmic Trading Strategies
Any strategy for algo trading requires an identified chance which will be rewarding when it comes to improved gains or cost reduction. The following are common trading strategies used in algo trading:
Trend Following Strategies
The most common algorithmic trading strategies follow fads in moving station breakouts, averages, price level moves and technical indicators that are related. These are most straightforward and the easiest strategies to execute through algorithmic trading because these strategies don’t involve making any predictions or price outlooks. Trades are commenced depending on the incidence of desired tendencies, which are easy and straightforward without getting into the complexity of predictive analysis to implement. The aforementioned example of 200 and 50 day moving average is a popular trend following strategy.
Arbitrage Opportunities
Purchasing a dual listed stock at a lower cost in one market and simultaneously selling it at an increased price in another marketplace offers the price differential as risk free gain or arbitrage. The same operation can be duplicated for stocks versus futures instruments, as price differentials do exists from time to time. Implementing an algorithm to identify such price differentials and placing the orders enables lucrative opportunities in efficient manner.
Index Fund Rebalancing
Index funds have defined periods of rebalancing to bring their holdings to level with their respective benchmark indices. This creates opportunities that are lucrative for algorithmic dealers, who capitalize on anticipated trades that offer 20-80 basis points gains depending upon how many stocks in the index fund, only prior to index fund rebalancing. Such trades are initiated via algorithmic trading systems for best costs and timely performance.
Mathematical Model Based Strategies
A lot of proven mathematical models, like the delta-neutral trading strategy, which enable trading on combination of its underlying security and alternatives, where trades are placed to cancel positive and negative deltas so that the portfolio delta is kept at zero.
Trading Range (Mean Reversion)
Mean reversion strategy is dependant on the idea the low and high costs of an asset are a temporary phenomenon that revert to their mean value periodically. Identifying and explaining a price range and implementing algorithm based on that allows trades to be put automatically when cost of advantage breaks in and out of its defined range.
Percent of Volume (POV)
Until the commerce order is fully filled, this algorithm continues sending partial orders, based on the defined contribution ratio and according to the volume traded in the markets.
Implementation Shortfall
The implementation shortfall strategy aims at minimizing the performance cost of an order by trading off the real time marketplace, thereby saving on the cost of the order and benefiting in the opportunity cost of delayed performance. The participation speed that is targeted will be increased by the strategy when the stock price moves positively and decrease it when the stock price moves adversely.
Beyond the Usual Trading Algorithms
There are a few special classes of algorithms that try to identify “happenings” on one other side. These “sniffing algorithms,” used, for instance, by a sell side market maker have the inbuilt intelligence to identify the existence of any algorithms on the buy side of a large order. Such detection through algorithms will help the market maker identify large order opportunities and enable him to gain by filling the orders at a cost that is higher. This is occasionally identified as high-tech front-running. (For more on high frequency trading and deceptive practices, see: If You Buy Stocks Online, You Are Involved in HFTs.)
Time Weighted Average Price (TWAP)
Time weighted average cost strategy breaks up a large order and releases determined smaller balls of the order to the marketplace using equally split time slots between a start and ending time. The intention is to carry out the order close to the average cost between the end and start times, thereby minimizing market impact.
Volume Weighted Average Price (VWAP)
Quantity weighted average cost strategy breaks up a large order and releases determined smaller balls of the order to the market using stock particular historic volume profiles. The aim would be to carry out the order close to the Volume Weighted Average Price (VWAP), therefore gaining on average cost.
Educational material for basics of algorithmic trading
TEDxNewWallStreet – Sean Gourley – High frequency trading and the new algorithmic ecosystem
See the video by Dr. Sean Gourley. He is the founder and CTO of Quid and physicist by training and has studied the mathematical patterns of war and terrorism. He is building tools to augment human intelligence.
Algorithmic Trading– Impact of Automated Trading Programs On Markets Documentary
Learn about the impact of automated trading systems on today’s markets. While this documentary focuses on stocks, the same factors are at work in the Forex markets. High frequency, algorithmic trading programs work quickly and create huge volatility. This excellent documentary Money & Speed is from VPRO which is required viewing for all traders.
Documentary: Money & Speed: Inside the Black Box
Money & Speed: Inside the Black Box is a thriller based on actual events that takes you to the heart of our automated world. Based on interviews with those directly involved and data visualizations up to the millisecond, it reconstructs the flash crash of May 6th 2010: the fastest and deepest U.S. stock market plunge ever. A rare opportunity to experience what is happening inside the black boxes of our rapidly evolving financial markets.
TEDxConcordia – Yan Ohayon – The Impact of Algorithmic Trading
Yan Ohayon demystifies and shares his experience with algorithmic trading and its impact on markets, our lives, and everything in between.
Quants: The Alchemists of Wall Street – A Documentary about algorythmic trading
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