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Basics of Algorithmic Trading

(automated trading, black-box trading, or simply algo-trading) is the process of using computers programmed to follow a defined set of instructions for placing a trade in order to generate profits at a speed and frequency that is impossible for a human trader. The defined sets of rules are based on timing, price, quantity or any mathematical model. Apart from profit opportunities for the trader, algo-trading makes markets more liquid and makes trading more systematic by ruling out emotional human impacts on trading activities.

Suppose a trader follows these simple trade criteria:

Buy 50 shares of a stock when its 50-day moving average goes above the 200-day moving average
Sell shares of the stock when its 50-day moving average goes below the 200-day moving average

Using this set of two simple instructions, it is easy to write a computer program which will automatically monitor the stock price (and the moving average indicators) and place the buy and sell orders when the defined conditions are met. The trader no longer needs to keep a watch for live prices and graphs, or put in the orders manually. The algorithmic trading system automatically does it for him, by correctly identifying the trading opportunity. (For more on moving averages, see: Simple Moving Averages Make Trends Stand Out.)

Algo-trading provides the following benefits:

Trades executed at the best possible prices

Instant and accurate trade order placement (thereby high chances of execution at desired levels)

Trades timed correctly and instantly, to avoid significant price changes

Reduced transaction costs (see the implementation shortfall example below)

Reduced risk of manual errors in placing the trades

Backtest the algorithm, based on available historical and real time data

Reduced possibility of mistakes by human traders based on emotional and psychological factors