How does automated trading work?

In the world of stock trading these days, algo trading is all the buzz. But before you decide whether or not you should dive headfirst into this novel concept and employ algo trading strategies to make the most of earning opportunities in the stock market, you should know how algo trading works. Algo trading is basically feeding algorithms to a computer as a finite set of instructions in order to obtain specific results.

In algo trading, the computer can be programmed to execute orders based on the market signals. Since the computers are more apt at handling large quantities of data, they are able to evaluate market conditions more efficiently to decide how the buying and selling decisions should be made. In fact, algo trading is so effective that it has taken over 40% of all stock trades on the National Stock Exchange (NSE) in India. Let us take at how exactly algo trading strategies work:

Formulating a strategy

Much like manual trading, automated trading also relies on creating a winning strategy. Trend following strategy, mean reversal strategy, arbitrage, statistical arbitrage, or market marking are some of the pre-defined fool proof strategies that one can program in the computers. You also need to make sure that you pre-program entry and exit positions; you can also minimize your risk by including contingencies like stop loss and profit limit.

Writing an algorithm

Once you have formulated a strategy, you need to write an algorithm to tell your computer how to execute that strategy. Once the algorithm is prepared, you need to get it approved by a chartered accountant. If it is passed by the CA, you need to take it to the exchange and demonstrate the strategy and how it has been converted into a workable algorithm. If it is passed there as well, it becomes ready to use in the world of automated trading.

Building or buying trading software

Software like Streak, MetaTrader, and AmiBroker are some of the most popular automated trading software that have produced results for a lot of people. Once you have the software, you’ll also need to buy data feeds from a vendor so that the algorithms that you have written can generate signals based on those live feeds.

Trading

Once you have completed all the above steps, the rest of the work is pretty easy. After you set up your system, all you need to do is look at the signals that are generated by the algorithm and then respond to them accordingly.