What is Algo Trading and how does it work?

by?William Naranjo?on September 10, 2022

What is Algorithmic Trading or Algo Trading?

By utilizing sophisticated mathematical tools and models, algorithmic trading aids in the decision-making process for trading on the stock market. Black-box trading and automated trading are other names for it. In algorithmic trading, orders are placed by a computer program that adheres to a predetermined set of rules. When a certain set of requirements are met, buy or sell orders are fired. Market data is continuously examined for these conditions.

Trading with algorithms can generate good returns at a speed and frequency that is not attainable for people. All of the predetermined trading guidelines are based on timing, amount, price, etc. This trading strategy will be used by all institutions that process several orders each day.

The algo trading system gathers data from the exchange, uses it to create a method, and then executes the trade. Previously, orders for trade execution were placed over the phone after the data had been manually collected for trading. However, automated trading is now a reality. The entire procedure of gathering market information and carrying out orders has been automated.

Components of Algo Trading System

The Algorithmic Trading Platform has three key components that work together to assist obtain the information needed to place orders:

• Market Data Adapter
• Complex Events Processing Engine
• Order Routing/Management System

Let’s examine each of these elements individually.

Market Data Adapter:

This is the first section, which transforms the exchange data into a format that a trading system can comprehend. Knowing this is crucial since the exchange sends out raw data that is made up of fragments of data packets. The adaptor will automatically store this data in the orders after processing it.

Let’s use an illustration to comprehend it. Currently, the National Stock Exchange (NSE) offers live market data in the form of files on its servers. Systems are created by data vendors to read these binary files and transform them into readable data. These data vendors’ APIs (application programming interfaces) are used to access this data.

In other words, gathering market data will be the initial stage in designing your own Algo trading system. You can obtain it through exchange-approved data providers or straight from exchange. You can then feed the data to your program for additional processing.

It’s interesting to note that several discount brokers are offering APIs for small retail investors that may be quickly used to obtain market data for “PERSONAL” use at affordable pricing.

Example Zerodha offers the Kite API for quick market data retrieval.

Complex Events Processing Engine:

This is the main part of the Algo trading system, and here the whole magic takes place. The market data , which is fetched , is now analyzed based on complex data points analysis and technical indicators analysis . Usually we write custom algorithms , or set of rules , based on which Buy or Sell view is generated in any stock or financial instrument.

Let’s take an example to understand it better.

I may design a trading rule where i buy a stock when

• Its current market price crosses 200 day moving average
• Todays volume is more than 5 days average volume

Therefore, we evaluate if any stock complies with the aforementioned two criteria by scanning the most recent price and market data every few seconds. When these circumstances are met, we receive a signal to purchase or sell.

This is merely a very basic illustration. Algorithms search the stock markets in real time, scanning hundreds of data points each second for chances.

Order Routing/Management System:

This stage of the process receives the directives from a sophisticated events processing engine and transforms them into a programming language. Following that, orders are sent to the exchanges either directly or through a third party broker.

In algo trading, orders are typically placed with distinct entry and exit levels.

How can you do Algorithmic Trading?

To start algo trading, you have to formulate your strategy like

• For which set of stocks you want to trade through algo
• Design Entry and Exit Rules
• Backtest your strategy on Past data and see if its working well
• Deploy the strategy in Real markets with Risk and money management

Remember, you must thoroughly backtest your approach using historical data to determine whether it is performing well in the present market. Once it is finished, you should turn it into an algorithm program and upload it to the server, where it will continue to look until it finds a match that is appropriate for your trade. Your trade is finished and automatically transferred to the exchange once that has been decided.

How is algorithmic trading Beneficial in the Financial markets?

• Human errors and emotional activity can be avoided completely.
• A high volume of trades can be easily placed, whereas it is not feasible for the human trader.
• Algo trading performs at high speed with accuracy.
• Algo trading is highly effective in processing the previous data, which can be backdated from the last ten years.
• Highly Disciplined, since the instructions are programmed previously.
• While doing algo trading, you never miss a single trade that suits your parameters.
• You can observe all the markets in the exchange every moment for a given standard.
• Reduce Transaction Cost

by?William Naranjo?on September 10, 2022

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