Why Algorithmic Trading Is Gaining Popularity
Did you know that around 60% to 73% of trades are from algorithmic trading accounts? That high percentage makes up the majority of U.S. equity trading, and also a significant percentage of futures trading. With that, it's not hard to realize the potential in more automatic forms of trading.
As the traditional markets become more and more turbulent, active investors and traders are looking for new ways to manage their portfolios and maximize their profits. One method that is gaining and retaining popularity is algorithmic trading. This approach relies on computers to automatically trade stocks and other securities based on predetermined rules.
While there are some risks associated with this type of trading, it can be a very effective way to manage your portfolio. We're going to go back to the basics a bit and explain what this form of trading is. We'll also take a look at some of the current and growing benefits the practice offers and outline where its popularity has come from.
If you're wondering what all of the excitement is about when it comes to algo trading, stick around and keep reading while we break it down.
As the traditional markets become more and more turbulent, active investors and traders are looking for new ways to manage their portfolios and maximize their profits. One method that is gaining and retaining popularity is algorithmic trading. This approach relies on computers to automatically trade stocks and other securities based on predetermined rules.
While there are some risks associated with this type of trading, it can be a very effective way to manage your portfolio. We're going to go back to the basics a bit and explain what this form of trading is. We'll also take a look at some of the current and growing benefits the practice offers and outline where its popularity has come from.
If you're wondering what all of the excitement is about when it comes to algo trading, stick around and keep reading while we break it down.
What Is Algorithmic Trading Exactly?
Algorithmic trading, also known as algo trading, is a system that uses simple (or complex) mathematical formulas and models to make decisions about buying or selling securities. It's not as difficult of a concept to grasp as it comes off, though. Essentially, it reduces the human emotion and high level of error out of trading by following a predetermined set of rules.
This automated form of trading has been around for quite some time, and most people don't know that it's been gaining even more popularity since the early 1980s. The excitement around this method has grown exponentially, and that's because it is more of a rule-based strategy. In short, the way you set up the algorithm will be the way that it operates.
The main reason algo trading has become so popular in recent years is due to the advancement of technology. To be successful, algo traders need access to data in real-time and also historical data in order to backtest. They also need powerful computing resources to process all of that information faster.
In the past, only large financial institutions and hedge funds had the technology and resources to take advantage of this form of trading. However, that all changed with the advent of cloud computing and powerful trading platforms that are now available to retail investors.
This style of trading, or at least automated trading in particular, which is a subset of algo trading, may have started back in 1949, but it has developed in multiple ways since then. This is especially true given that you can trade across multiple markets and with different assets faster and more efficiently than ever.
We'll touch on when algo trading actually got started later in the article. Let's take a close look at some of the benefits that have shaped its popularity.
This automated form of trading has been around for quite some time, and most people don't know that it's been gaining even more popularity since the early 1980s. The excitement around this method has grown exponentially, and that's because it is more of a rule-based strategy. In short, the way you set up the algorithm will be the way that it operates.
The main reason algo trading has become so popular in recent years is due to the advancement of technology. To be successful, algo traders need access to data in real-time and also historical data in order to backtest. They also need powerful computing resources to process all of that information faster.
In the past, only large financial institutions and hedge funds had the technology and resources to take advantage of this form of trading. However, that all changed with the advent of cloud computing and powerful trading platforms that are now available to retail investors.
This style of trading, or at least automated trading in particular, which is a subset of algo trading, may have started back in 1949, but it has developed in multiple ways since then. This is especially true given that you can trade across multiple markets and with different assets faster and more efficiently than ever.
We'll touch on when algo trading actually got started later in the article. Let's take a close look at some of the benefits that have shaped its popularity.
What Are the Benefits of Algorithmic Trading?
There are several reasons why algo trading has become so popular among more active traders and investors. The great thing about this form of trading is that you can set it up to be almost passive. Of course, you're going to have to assess the market a bit on your own at the start and on somewhat of an ongoing basis.
But with algo trading, you can often give yourself higher chances of executing your trades at more desired levels and at more accurate times. Let's take a look at some of the undeniable benefits of automated trading.
Increased Speed
Algorithmic trading can help you take advantage of opportunities in the market much faster than if you were trading manually. To be specific, if you don't know how fast algo trading operates, try thinking in the form of milliseconds. These automated systems can process orders within two milliseconds, and frequently even less.
You might even think that isn't a big deal if you're a professional trader. Actually, being a professional trader with years of market strategy experience has nothing to do with it. The truth is that humans have limitations.
It takes the human eye 400 milliseconds just to blink, and that's for the average person. Even if your ability to blink is a bit faster, it'll still take you anywhere between 300 milliseconds and the average 400 to do so. Try comparing that to how fast an automated algorithm can process a trade and then decide which option is more quick and efficient.
Improved Market Liquidity
Algorithmic trading can help improve market liquidity by providing more buyers and sellers in the market. This can lead to tighter spreads and better prices for all investors overall.
It's able to do this by reducing the frictions and the different costs of trading. Using a more technologically-based strategy will allow you to facilitate hedging better and even reduce the cost of capital in general.
Reduced Risk of Human Error
This is a big one and limiting error is an obvious benefit. Reducing risk is one of the biggest benefits of algo trading because it takes a lot of emotion and overthinking out of the equation. When you're relying on a computer to make decisions, you're less likely to make mistakes that can cost you money.
Additionally, you can expect trades to be executed at better prices. This doesn't just mean reduced prices; this means the overall cost in general compared to other stock options. Not only that, with automated trading, you aren't just getting the benefit of speed.
You're getting trades that are specifically timed to be instantaneous and avoid those pesky and oftentimes unforeseeable price changes. Some traders often overlook the fact that algorithmic trading can be back-tested as well.
This means that you can use real-time data and historical data sets to test out different strategies for viability. If you like to identify and test out different trends, this could be a huge benefit for you.
But with algo trading, you can often give yourself higher chances of executing your trades at more desired levels and at more accurate times. Let's take a look at some of the undeniable benefits of automated trading.
Increased Speed
Algorithmic trading can help you take advantage of opportunities in the market much faster than if you were trading manually. To be specific, if you don't know how fast algo trading operates, try thinking in the form of milliseconds. These automated systems can process orders within two milliseconds, and frequently even less.
You might even think that isn't a big deal if you're a professional trader. Actually, being a professional trader with years of market strategy experience has nothing to do with it. The truth is that humans have limitations.
It takes the human eye 400 milliseconds just to blink, and that's for the average person. Even if your ability to blink is a bit faster, it'll still take you anywhere between 300 milliseconds and the average 400 to do so. Try comparing that to how fast an automated algorithm can process a trade and then decide which option is more quick and efficient.
Improved Market Liquidity
Algorithmic trading can help improve market liquidity by providing more buyers and sellers in the market. This can lead to tighter spreads and better prices for all investors overall.
It's able to do this by reducing the frictions and the different costs of trading. Using a more technologically-based strategy will allow you to facilitate hedging better and even reduce the cost of capital in general.
Reduced Risk of Human Error
This is a big one and limiting error is an obvious benefit. Reducing risk is one of the biggest benefits of algo trading because it takes a lot of emotion and overthinking out of the equation. When you're relying on a computer to make decisions, you're less likely to make mistakes that can cost you money.
Additionally, you can expect trades to be executed at better prices. This doesn't just mean reduced prices; this means the overall cost in general compared to other stock options. Not only that, with automated trading, you aren't just getting the benefit of speed.
You're getting trades that are specifically timed to be instantaneous and avoid those pesky and oftentimes unforeseeable price changes. Some traders often overlook the fact that algorithmic trading can be back-tested as well.
This means that you can use real-time data and historical data sets to test out different strategies for viability. If you like to identify and test out different trends, this could be a huge benefit for you.
What Are Some of the Risks Associated With Algo Trading?
While algo trading does offer multiple potential benefits, there are also some risks to be aware of. Let's look at some of the main risks.
Black Box Risk
When you rely on a computer to make decisions for you, there's always the risk that something could go wrong. This could be thought of as a "black box risk" because you're putting your trust in a machine that you may not fully understand.
Now, in case you don't know what this means, a block box, or black box problem, is a type of program or system that will let you see the different associated inputs and outputs but none of the in-between. That can be a bit frightening, but that's part of deep learning systems and using them to do trading for you.
In short, what you input is going into a black box, an area where you can't see what's going on internally. However, you can see what comes out at the end. The good news here is that your algorithm will often operate within the restraints of how it's designed.
This means that if you have extensive knowledge of different programming languages, you can prepare any system to do what you tell it to, in basic terms. Of course, it's a bit more complicated than that, but someone with algo trading experience and coding experience may have a bit of an easier time.
One of the best things that you can do in this situation is to refer to more of our content to explore other ways to navigate trading in general. You can also partner with us and join in on one of our workshops if you're interested in taking the complexity out of any trading algorithm and trading monitoring.
Outages and System Failures
Like any computer system, an algo trading system is susceptible to outages and failures. If your system goes down, you could miss out on important market opportunities.
This isn't necessarily a huge issue considering anything you do digitally is susceptible to this. However, it's something to be aware of so you can better safeguard your strategies, especially if you'll be doing any offline coding.
Security Risks
Because algo trading involves the use of sensitive data and financial resources, it's also susceptible to security risks such as hacking and cyber theft. Since 63% of the world's total population is connected to the internet, which can also be translated into businesses and remote operations, this is inevitable in some ways.
So, this may not be as much of a risk as it seems if you're using proper data protection software to protect your private information. One of the best ways you can do this is to designate a trade-secret compliance professional.
Depending on how large your trading operation is, this could be necessary. You could also encrypt your files or any software that you use to help limit any potential security risks.
Despite these risks, algo trading is still a viable option for traders and investors alike who are looking to take advantage of market opportunities.
Black Box Risk
When you rely on a computer to make decisions for you, there's always the risk that something could go wrong. This could be thought of as a "black box risk" because you're putting your trust in a machine that you may not fully understand.
Now, in case you don't know what this means, a block box, or black box problem, is a type of program or system that will let you see the different associated inputs and outputs but none of the in-between. That can be a bit frightening, but that's part of deep learning systems and using them to do trading for you.
In short, what you input is going into a black box, an area where you can't see what's going on internally. However, you can see what comes out at the end. The good news here is that your algorithm will often operate within the restraints of how it's designed.
This means that if you have extensive knowledge of different programming languages, you can prepare any system to do what you tell it to, in basic terms. Of course, it's a bit more complicated than that, but someone with algo trading experience and coding experience may have a bit of an easier time.
One of the best things that you can do in this situation is to refer to more of our content to explore other ways to navigate trading in general. You can also partner with us and join in on one of our workshops if you're interested in taking the complexity out of any trading algorithm and trading monitoring.
Outages and System Failures
Like any computer system, an algo trading system is susceptible to outages and failures. If your system goes down, you could miss out on important market opportunities.
This isn't necessarily a huge issue considering anything you do digitally is susceptible to this. However, it's something to be aware of so you can better safeguard your strategies, especially if you'll be doing any offline coding.
Security Risks
Because algo trading involves the use of sensitive data and financial resources, it's also susceptible to security risks such as hacking and cyber theft. Since 63% of the world's total population is connected to the internet, which can also be translated into businesses and remote operations, this is inevitable in some ways.
So, this may not be as much of a risk as it seems if you're using proper data protection software to protect your private information. One of the best ways you can do this is to designate a trade-secret compliance professional.
Depending on how large your trading operation is, this could be necessary. You could also encrypt your files or any software that you use to help limit any potential security risks.
Despite these risks, algo trading is still a viable option for traders and investors alike who are looking to take advantage of market opportunities.
Mapping Out Algo Trading From Its Start to Its Current Level of Popularity
Algorithmic trading has been around for a while. In fact, the first recorded use of it dates back to the early 1970s when the Nasdaq Stock Market introduced the idea of electronic order matching. This system allowed market makers to enter their buy and sell orders which were then matched with other traders.
However, it wasn't until the late 1990s that algo trading really started to take off. This is due in large part to advances in technology and computer processing power. Traders began to develop algorithmic trading systems that could make split-second decisions based on a variety of factors.
Prior to its start, humans had to make all of the trading decisions. This left a lot of room for error as well as opportunities for trades to be missed.
The popularity of algorithmic trading continued to grow in the early 2000s. In 2005, high-frequency trading (HFT) firms began using algorithms to trade securities. This type of trading's defined as transactions that are executed at a very fast pace and rely on automated decision-making processes.
The global financial crisis in 2008 led to even more interest in algorithmic trading. Many investors lost faith in traditional investment methods and were looking for new ways to protect their portfolios and make money. Think about it like this, an algorithm that can pull you out or enter you into a new trading opportunity based on parameters you set is also a safety mechanism in some ways.
Algorithmic trading systems have continued to evolve since then. They are now able to take into account a wider range of data sources and execute trades much faster than we could have before.
Personally, when I trade futures, probably 99% of it is based on algos, and most of that trading is automated. I do have to manually perform rollovers of futures contracts, but I have found the more automation, the better.
However, it wasn't until the late 1990s that algo trading really started to take off. This is due in large part to advances in technology and computer processing power. Traders began to develop algorithmic trading systems that could make split-second decisions based on a variety of factors.
Prior to its start, humans had to make all of the trading decisions. This left a lot of room for error as well as opportunities for trades to be missed.
The popularity of algorithmic trading continued to grow in the early 2000s. In 2005, high-frequency trading (HFT) firms began using algorithms to trade securities. This type of trading's defined as transactions that are executed at a very fast pace and rely on automated decision-making processes.
The global financial crisis in 2008 led to even more interest in algorithmic trading. Many investors lost faith in traditional investment methods and were looking for new ways to protect their portfolios and make money. Think about it like this, an algorithm that can pull you out or enter you into a new trading opportunity based on parameters you set is also a safety mechanism in some ways.
Algorithmic trading systems have continued to evolve since then. They are now able to take into account a wider range of data sources and execute trades much faster than we could have before.
Personally, when I trade futures, probably 99% of it is based on algos, and most of that trading is automated. I do have to manually perform rollovers of futures contracts, but I have found the more automation, the better.
Get Guidance When You Need It Most
KJ Trading Systems is dedicated to teaching how to build award-winning algo trading systems. We know that algorithmic trading can come off as complex, and it is but with the right approach, it can be implemented with ease. Algorithmic trading systems can trade around the clock, even while you sleep.
The speed and accuracy it offers are also unrivaled. It's understandable with all of its benefits if you want to enter into the game. However, make sure you enter on the right foot and connect with us through a workshop today to see how we can help.
The speed and accuracy it offers are also unrivaled. It's understandable with all of its benefits if you want to enter into the game. However, make sure you enter on the right foot and connect with us through a workshop today to see how we can help.
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About The Author: Kevin Davey is an award winning private futures, forex and commodities trader. He has been trading for over 25 years.Three consecutive years, Kevin achieved over 100% annual returns in a real time, real money, year long trading contest, finishing in first or second place each of those years.
Kevin is the author of 5 highly acclaimed books, including "Building Algorithmic Trading Systems: A Trader's Journey From Data Mining to Monte Carlo Simulation to Live Trading" (Wiley 2014). Kevin provides a wealth of trading information at his website: https://www.kjtradingsystems.com
Copyright, Kevin Davey and KJ Trading Systems. All Rights Reserved. Reprint of above article is permitted, as long as the About The Author information is included.
Kevin is the author of 5 highly acclaimed books, including "Building Algorithmic Trading Systems: A Trader's Journey From Data Mining to Monte Carlo Simulation to Live Trading" (Wiley 2014). Kevin provides a wealth of trading information at his website: https://www.kjtradingsystems.com
Copyright, Kevin Davey and KJ Trading Systems. All Rights Reserved. Reprint of above article is permitted, as long as the About The Author information is included.