Is algorithmic trading profitable? (2024)

Algorithmic trading uses financial markets and computer programming to execute trades at precise times. It aims to remove emotions from trades to ensure that trades are executed efficiently.

In this article, we’ll look at algorithmic trading, pros and cons, trading strategies and if it’s profitable.

Computerized trading systems were introduced in the 1970s

After computerised trading systems were introduced to the US financial markets in the 1970s, the use of trading algorithms increased. The New York Stock Exchange introduced its designated order turnaround system in 1976 to route orders from traders to exchange floor specialists.

Over the next few decades, exchanges improved their ability to accept electronic trading. By 2009, over 60% of all US trades were executed by computers.

What is algorithmic trading?

Algorithms are rules or instructions used in financial trading. They are designed to make trading decisions automatically. Algorithms range from simple single-stock trading systems to more complicated black-box algorithms that analyse financial data, market conditions, and price movements to execute trades at the best times for the lowest cost-to-maximum profit ratio.

Algorithmic trading strategies

The following are a few common trading strategies used in algorithmic trading:

Trend-following

The most popular algo trading techniques follow trends in channel breakouts, moving averages, price level movements, and technical indicators. Since these strategies do not require any predictions or price forecasts, they are the simplest strategies to use with algorithmic trading. Trades are based on favourable trends, which are easy to implement using algorithms. One popular trend-following strategy is to use 50- and 200-day moving averages.

Arbitrage opportunities

When a dual-listed stock is bought at a lower price in one market and simultaneously sold at a higher price in another market, the price difference is risk-free profit or arbitrage. By implementing an algorithm to identify price differences and placing orders efficiently, profits can be made.

Mathematical model-based strategies

Trading on a combination of options and the underlying security is allowed by mathematical models, such as the delta-neutral trading strategy. This portfolio strategy consists of a number of positions with offsetting positive and negative deltas—a ratio that compares the change in the price of an asset to the corresponding change in the price of its derivative.

Trading range (mean reversion)

The idea behind mean reversion strategy is that the high and low prices of an asset are temporary and return to their mean value, or average value. By identifying and defining a price range and applying an algorithm based on it, trades can be placed automatically when the price of an asset breaks in and out of its defined range.

Volume-weighted average price (VWAP)

Volume-weighted average price strategy divides up a large order into smaller chunks that are released to the market. The goal is to execute the order close to the volume-weighted average price (VWAP).

Time-weighted average price (TWAP)

This price strategy uses evenly spaced time slots between a start and end time to break up a large order into smaller, dynamically determined chunks that are released to the market. The aim is to minimise market impact by executing the order close to the average price.

The goal is to minimise the impact on the market by executing the order close to the average price between the start and end times.

Pros and Cons of algorithmic trading

Pros

1. The best possible prices are often used to execute trades.
2. Trade orders can be placed instantly and accurately, with a high probability of execution at the desired levels. Trades are executed at the right time to avoid large price changes.
3. Reduced transaction costs.
4. Simultaneous automated checks on numerous market conditions.
5. There is no risk of human error when placing trades.
6. Algorithmic trading can be backtested with historical and real-time data.

Cons

1. Algorithmic trading depends on rapid execution times and minimal latency, which is the delay in a trade execution. There may be missed opportunities if a trade is not executed quickly.
2. To forecast future market movements, algorithmic trading relies on historical data and mathematical models. But unexpected market disruptions, referred to as black swan events, can happen and result in losses.
3. Algorithmic trading depends on technology, such as computer programs and fast internet connections. Technical issues can affect the trading process and lead to losses.
4. Market prices can be significantly impacted by large algorithmic trades, and traders who are unable to adjust their trades may have losses. Algo trading may also cause increasing market volatility at times, leading to flash crashes.
5. Algorithmic trading is subject to a number of complex rules and regulations, which can be time-consuming to follow.
6. Developing and implementing algorithmic trading systems can be expensive, and traders may need to pay fees for data feeds and software.
7. Because algorithmic trading systems are based on pre-defined rules and instructions, this may limit traders ability to customize their trades to their specific needs.
8. Algorithmic trading relies on mathematical models and past data. It ignores the subjective and qualitative elements that can impact market movements. The absence of human judgment can be a disadvantage for traders who want a more intuitive approach to trading.

Technical requirements for algorithmic trading

The final part of algorithmic trading is implementing the algorithm using a computer program in combination with backtesting (testing the algorithm on historical periods of past stock-market performance to see if it would have been profitable). It involves transforming the identified strategy into an integrated computerised process that has access to a trading account for placing orders. The requirements for algo trading are outlined below:

• Computer-programming knowledge to program the necessary trading strategy using hired programmers or pre-made trading software.
• Connectivity to network and access to trading platforms to place orders.
• Access to market data feeds that the algorithm will monitor for opportunities to place orders.
• The ability and infrastructure to backtest the system after it is built before launching it on real markets.
• Historical data is available for backtesting based on the complexity of the rules implemented in the algorithm.

Can you make money with algorithmic trading?

Algorithmic trading can be profitable. It can provide a more disciplined, systematic approach to trading, which may help traders execute trades more efficiently than a human trader could. Additionally, traders can execute trades at the best possible prices with algorithmic trading and avoid the influence of human emotions on trading decisions.

It is crucial to remember that algorithmic trading has the same risks and uncertainties as any other type of trading, and even with an algorithmic trading system, traders may still have losses. In addition, most regular traders cannot afford to develop and implement an algorithmic trading system and may need to pay fees for software and data feeds.

Furthermore, most regular traders cannot afford the development and implementation of an algorithmic trading system; additionally, traders may have to pay recurring fees for data feeds and software. Prior to making any decisions, as with any type of investing, it is crucial to thoroughly investigate and comprehend the potential risks and rewards.

Final thoughts

Algorithmic trading provides speed, efficiency, and objectivity in trading decisions. It can minimise the risk of human error, automate entry and exit points, and prevent information leaks. But it also carries significant risks: it’s dependent on complex technology that can break down or be hacked, and high-frequency trading can increase system risk.

Other possible risks include execution errors, market volatility, and technical glitches. It is dependent on complicated technology, which may malfunction or be compromised, and high-frequency trading may increase systemic risk, among other serious risks. Other possible risks include execution mistakes, market volatility, and technical difficulties.

Disclaimer:
This information is not considered investment advice or an investment recommendation, but instead a marketing communication. IronFX is not responsible for any data or information provided by third parties referenced or hyperlinked in this communication.