A Retail Investor’s Guide to Algorithmic Trading

January 20, 2022 Shubhi Gupta

What is Algorithmic Trading?

Trades are made following a set of predetermined rules under Algorithmic trading. Algo trading uses trading software to store trading instructions in the form of algorithms and variables such as volume, time, and price references. The computer then follows the instructions contained in the algorithm and executes the trade deal accordingly. This process makes the trading prices more accurate, properly executed, well-timed, and free of human errors.

Why Should Retail Traders Do Algorithmic Trading?

Retail traders have been deprived of the opportunity to trade through the process of algorithmic trading for an extended time. But currently retail traders have started showing great interest in entering the Algo trading world. Even companies and brokers have begun supporting Retail Algorithmic traders.

Retail traders must be aware that to smoothly trade-in Algorithmic trading space, they should have sound knowledge of everything surrounding Algo trading and investment. Not being able to participate in algorithmic trading can harm retail traders as algorithmic traders often tend to have the upper hand over manual traders.

Let us look at the benefits that the retail traders will miss if they fail to start with algorithmic trading.

Better accuracy:

One of the main advantages of algorithmic trading compared to manual trading is the accuracy with which the trade deals are made. Since human involvement is greatly eliminated in algorithmic trading, the chances and frequency of human errors is vastly minimized. All algorithms are checked multiple times and thus are free of any human mistakes.

1. A Larger Market volume

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With the help of Algorithmic trading, a vast number of shares can be traded on the exchange in a brief period. Therefore, the overall market trade value per day and the market liquidity level are higher. The whole trading exercise has also become relatively more simplified and systematic.

2. Enables diversification in trading

Since trades are executed using technology software, it becomes possible to execute numerous strategies and invest in different trades, all at the same time. Computers and algorithms are used in algorithm trading. Hence, the process of implementing several trades and strategies simultaneously becomes effortless; this aids diversification in trading.

3. Cross-validation

Any newly formed algorithms first go through backtesting, a form of cross-validation wherein the validity of models is tested using past data. The result of this process shows if the algorithm is viable to use. If the results are not satisfactory, then appropriate modifications can be made to suit the particular needs of the traders.

4. Improved speed

Another vital advantage of algorithm trading is that it provides better speed. The algorithm can identify and act on different characteristics of the stock and trend/technical indicators in a matter of seconds.

5. Delivering best prices to traders

As we have already seen, massive volumes of trade can be executed thanks to algorithmic trading. As a result, many deals are made at a time which leads to lower transaction costs. Additionally, with the help of algorithmic trading, trades are made at the most efficient price, thus enabling traders to reap enormous profits.

6. Help in maintaining discipline and consistency among traders

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It is a well-known fact that planning and successfully executing a trading strategy is one of the most challenging tasks for investors. Since markets are highly unpredictable, traders often diverge from their plans due to fluctuations in the market. Algorithmic trading helps traders survive market volatility and remain consistent and disciplined with respect to their plans, irrespective of ups and downs. Also, the traders no longer need to continuously monitor the market movement in order to execute their strategies.

Common Algorithmic Trading Strategies: –

1. Trend-following strategies

These are the most easy-to-implement strategies since no price forecast or analysis is needed to apply these strategies. The method simply follows and acts on trend indicators. The algorithm looks out for trend changes and breakouts. Close monitoring and predictive analysis is thus not needed on the part of the trader under this strategy.

2. Arbitrage Strategies

If a stock is dually listed, an investor can profit or arbitrage by buying the stock at a comparatively lower price in one market and selling the same stock at a higher price in another market. The trader can use algorithmic trading to quickly identify price differentials across the market in order for the trader to indulge in arbitrage trading.

3. Index Fund Rebalancing Strategy

Under this strategy, profits are reaped before the index funds decide to rebalance their holding to be in sync with benchmark indices. The traders can have substantial earnings by using this strategy since index funds get rebalanced by about 20 to 80 basis points. Algorithmic trading aids the investor in getting deals at the best prices for higher profits.

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4. Trading Range

According to this strategy, the price trends converge to their mean values in the long run, and the price swings are only applicable in the short-term. Therefore, if the trader successfully identifies a price range and takes the position accordingly, he will benefit from it. The algorithm helps the investors do just that.

Conclusion

The decision about the algorithmic trading strategies to adopt, when and where to use these strategies, and what modifications are required to suit your needs is entirely on you. Thus retail traders should start their journey in algorithmic trading after having detailed know-how of all related concepts and facts. They must make time and efforts to go through the key points which will help them trade effectively. They should learn different types of algorithmic trading strategies prevalent in the market to be able to choose the one in line with their objectives. They should also be aware of the workflow of algorithmic trading. Also keep in mind that you are sufficiently experienced in trading.

Trustline is one of the best stock brokerage firms in India. As a reputed financial services company, Trustline allows customers to start trading with the facilities of all major Stock/ Commodity/ Currency exchanges for corporates, institutions & retail investors.