Algorithmic trading is a popular strategy that automates execution – making trading faster and minimising human error. Learn how to start building an algorithmic trading strategy and which algorithm platform to use.
What is algorithmic trading?
Algorithmic trading is a strategy that involves making decisions based on a set of rules that are then programmed into a computer to automate trades. The positions are executed as soon as the conditions are met.
Algorithmic trading has become incredibly popular in recent years, and now a significant portion of global trades are executed by machine-based algorithms. Previously, the strategy was only available to individuals who could do their coding, but now there are plenty of accessible 'off-the-shelf' programmes.
The main benefit of using algorithmic trading is that you can ensure your strategy isn’t impacted by sentiment or emotion, and that you stick to your trading plan. Algorithmic trading can also save you time, as you won't need to manually find entry and exit points, your computer will do it for you. This means you can leave your algorithm to run 24 hours a day.
The downside of a trading algorithm is that you might miss out on opportunities that don't fit into your program.
Algorithmic trading strategies
A lot of algorithmic strategies are kept to simple price action – buy EUR/USD when it hits X price, and sell it when it hits Y. But others are based on technical analysis indicators or a combination of the two. Let’s take a look at a few popular strategies.
Moving average trading algorithms
Moving average algorithmic strategies are potentially the most popular, given how simple they are to implement. Most markets rise and fall to trade near the average price over a period of time, so this strategy takes advantage of the smaller oscillations away from and toward this line.
This could also be classed as a mean reversion strategy.
The idea is to create a set of rules that gives the order to execute a trade when the market price is above or below the average market price. So, if you wanted to short oil, you might give the instruction to sell oil when the market rises above the 20-day moving average, believing it will correct itself.
Index re-balancing algorithms
Pension and retirement funds invest in index funds regularly. Their holdings have to be rebalanced – usually quarterly – as the underlying indices are updated for changing prices and market capitalizations.
This creates opportunities for algorithmic traders to exploit the trades that will have to take place, by buying and selling the shares that will be added and removed or reduced from the funds.
This algorithmic strategy isn’t that common, as most retail trading platforms can’t support the nano-second execution needed to make it work.
High-frequency arbitrage algorithms
High-frequency trading is the practice of placing a large number of orders quickly across different markets. While arbitrage is the strategy of finding and exploiting price differences between two markets.
By combining the two concepts, traders will seek to buy and sell large quantities of an asset that has a price imbalance.
Due to the extreme speeds that are needed – as these inefficiencies usually only last a matter of seconds – most traders will automate their strategies with algorithms.
But, as with index re-balancing strategies, this requires access to the best execution and fastest technology.
How to build an algorithm for trading
To build an algorithm for trading, you need to make sure you have:
- Computer access – including a reliable (and fast) internet network
- Coding capabilities – or access to ready-built solutions, such as MT4
- Financial market knowledge – not just at a basic level, but an expert understanding of each market and the factors that impact prices
- Risk management tools – you’ll need to have both stop-loss and take-profit conditions set to minimize risk and lock in profits
Algorithm trading platforms
There are a lot of different types of trading platforms that support algorithms and automated systems. While some traders choose to build their own, most will use ready-built platforms.
With FOREX.com, you can use MetaTrader 4 (MT4) as your algorithmic trading platform. Not only can you create your own algorithm, but you can use off-the-shelf examples created by other users and Expert Advisors.
These Expert Advisors will set custom parameters according to your strategy. This means you can execute orders automatically within your set specifications and not have to manually scour markets for trading opportunities.
MT4 also offers a range of indicators and add-ons to help supplement your algorithmic trading.
Algorithmic trading FAQs
What’s AI algorithmic trading?
AI algorithmic trading is the use of artificial intelligence and machine learning for developing trading systems. AI technology is capable of running updates on itself and finding ways to improve the algorithms to get better outcomes.
Is high-frequency trading an algorithmic strategy?
Yes, a lot of algorithmic strategies are high-frequency trades – a technique which aims to profit by placing a large number of orders quickly across different markets.
What are the risks of algorithmic trading?
Although appealing for a variety of reasons, automated trading systems should not be considered a substitute for carefully executed trading. Technology failures can happen, and as such, these systems do require monitoring. Remember, you should have some trading experience and knowledge before using automated trading systems and understand the risks involved.