Foreign exchange or Forex market is used to trade between currency and pairs. However, you should know that it is the most liquid market across the globe. But if you are new to trading, it is unlikely that Forex algorithmic trading is the first thing that will come to your mind.
Truth be told, algorithmic trading Forex is a vital part of trading. It is a process to execute a trade using computer programs for analyzing data and executing orders in the foreign exchange market. Traders of algorithm Forex depend on quantitative methods for decision making.
In our comprehensive guide to Forex algorithmic trading, we are going to tell you what it is, how it works, and the common algorithmic trading strategies.
So, without further delay, let’s proceed.
What is Forex Algorithmic Trading?
The idea of algorithmic trading techniques is pretty straightforward. It is primarily a technical term for automated trading. An algorithm is a series of mathematical rules created for the computer program to follow and solve a problem. When it is applied to Forex trading the problems focus on the combination of timing, price, and volume.
An algorithm has an entry, exit, and in-between points. There are different sets of rules that determine the risk. The rules can be simple or complex depending on the programmer. However, it is mostly complicated.
While writing the mathematical rules, you can base your criteria on the conventional price movements. However, you can also consider a more interconnected and intricate range of factors, including-
- Historical data
- Profit/loss ratios
- Breaking news
- Trends
The factors are analyzed within an environment with quickly moving conditions.
With algorithmic trading Forex, you can process all data effectively and instantly. The whole process will be complete in no time. Algorithms do not operate one at a time. In fact, you can run multiple algorithms simultaneously. So, you can follow an extensive range of strategies.
Things to Consider When Deciding on Algorithmic Trading Strategies
For your algorithm Forex trading strategies, you need to consider these factors.
- Risk
Whether swing trading, day trading, or investing, you should consider the risk correctly to make sure no one losing streak or trade puts them out of business. Any trade has the potential to succeed or fail. The interconnection between reward and risk with the probability of profit or loss creates variance.
Variance is the volatility of outcomes when you repeat the same trade. Managing your risk will keep you in the game for a longer period.
- Leverage
In Forex trading, traders use a concept known as leverage. It lets you control a large amount of trade money. It works in conjunction with risk management.
Leverage of 10x on a trade of $100 means, you control $1000 buying power. Moreover, the type of product you are trading can have a direct impact on the amount of risk and leverage. CFD or contract for difference products lets traders with a small account get considerable exposure to the price shift in currency pairs.
Leverage makes use of borrowed funds. Sure, you can gain big, but you can also lose a big amount. Furthermore, since it is borrowed funds, you might end up owing money in certain cases.
- Market Condition and Time Frame
Tunnel vision can plague newbies. These traders don’t consider anything beyond the technical indicators or charts. However, it can narrow down their view. Thus, they fail to analyze the market.
But all-inclusive trading systems check the current time frame and many higher or lower.
Also, a majority of currency trading works when you consider the overall market during the process of analysis.
- Goals
Everyone trades for different reasons. Some look to generate wealth while others want to improve their retirement plan. Your goals don’t have to depend on your earnings. However, when you are using algorithmic trading strategies, make sure you have regular milestones that will help in reviewing your performance system.
Advantages of Algorithmic Trading
There are many advantages of algorithm trading. Let’s take a look at a few of them.
- Minimizes Market Impact
A trade can change the market price, and these trades are known as distortionary trades as they can distort the market price. If you have to avoid such a situation, open a large position, which will move the market in steps.
For instance, an investor wants to buy a million shares in Apple and buys shares in batches of 1,000 shares. Now, the investor might want to purchase 1,000 shares every 5-minutes for an hour and then analyze the effect of the trade on the Apple stock’s market price. In case the price doesn’t change, the investor will keep purchasing.
Such a strategy will let the investor purchase Apple shares without amping up the price. Nevertheless, the strategy has two drawbacks-
- The strategy might take a lot of time to complete.
- In case the investor has to pay a fixed amount for each transaction he is making, the strategy will incur considerable transaction costs.
With an algorithmic trading strategy, you can easily solve the problem as you buy shares and check if the purchase had an effect on the market price. It can reduce the total transactions needed to complete the purchase and the time needed to complete the trading process.
- Ascertains Rule-Based Decision-Making
Investors and traders tend to get influenced by emotion and sentiment and disregard the trading strategies. But algorithm will solve the problem by ascertaining that the trades stick to a pre-decided rule set.
- Allows Backtesting
Another advantage of algorithmic trading Forex strategies is that it lets you do backtesting. Traders find it difficult to understand the parts of the trading system that is working and the parts that are not, since they are unable to run the system on old data. With algorithmic trading, it is possible to run algorithms depending on the old data to find out if it would have worked in the past. The ability offers a big advantage as it allows the user to get rid of any flaws present in the trading system before making it live.
- Reduced Transaction Cost
With algorithmic trading Forex strategies, you will not have to spend much time monitoring the market since you can execute a trade without constant supervision. The significant time reduction for trading will reduce the transaction cost due to the saved opportunities.
Disadvantages of Algorithm Trading
Algorithmic trading comes with a few disadvantages, too. So, let’s take a look at them-
- Depends on Technology
The biggest disadvantage of this form of trading is it largely depends on technology. So, the trading orders are present in the system and not the server. In case the internet connection is lost, the order isn’t sent for execution.
Thus, the whole ideology of algorithmic trading changes. This will cause the traders to miss out on the chances and they lose money. The primary systemic issues with algorithmic trading might lead to large flash crashes of the whole market.
- Knowledge of Programming Process
For algorithmic trading, you will have to develop algorithms. Not every investor is tech-savvy. Thus, you might have to learn the whole process or hire someone. So, the need to have technical knowledge makes Forex algorithmic trading complicated for regular people.
- Not All Strategies can be Automated
There are some surefire trading strategies. But all strategies can’t be automated and transformed into an algorithm. Hence, you will not be able to use such algorithms in algo trading for Forex. It mitigates the potential to make more money by using more effective strategies simply because they cannot be automated.
Algorithmic Trading Strategies
Here are some of the most common trading strategies to use algo trading.
- Trend-Following Strategies
The common Forex algorithmic trading strategies follow trends in channel breakouts, Moving Averages, related technical indicators, and price level movements. These are some simple strategies to implement within algorithmic trading as they don’t make any price forecasts or predictions.
Trades are initiated depending on an incident of desirable trends that are easy to implement through algorithms even without getting involved in the intricacies of predictive analysis.
- Index Fund Rebalancing
Index funds come with defined periods of rebalancing for bringing the holdings at par with their corresponding benchmark indices. It leads to profitable opportunities for the traders of algorithmic trading, capitalizing on the expected trader, which provides 20%-80% basis point profits based on the number of stocks in the index fund. These trades are initiated through algorithmic trading for the best prices and timely execution.
- Arbitrage Opportunities
Purchasing a dual-lists stock at a low price in a market and then selling it at a higher price in a different market provides the price differential as arbitrage or risk-free profit. This operation can be replicated for future instruments vs. stocks, as price differences pop up from time to time. Using an algorithm for identifying such differences in price and placing the orders in an effective manner provides profitable opportunities.
- Mathematic Model-Based Strategies
Proven mathematical models, such as the delta-natural trading strategy lets you trade on underlying security and option combinations. Delta neutral is a portfolio strategy that has multiple positions with negative and positive delta- a ratio that compares the change in the asset price, generally marketable security to the corresponding change in the derivative price. Thus, the respective asset’s overall delta totals zero.
- Percentage of Volume
Unless the trade order is fulfilled, the algorithm will keep sending partial orders as per the volume traded in the market and defined participation ratio. The associated steps strategy sends orders at a percentage defined by the user of market volumes and augments or reduces the participation rate as the stock price reaches a specific level.
- Trading Range
The trading range or mean reversion strategy depends on the idea that the low and high prices of an asset are a temporary occurrence, which reverts to the mean value.Defining the price and then using the algorithm depending on it lets trades be placed automatically if the asset price breaks in and out of the defined range.
- High-Frequency Trading
Like the name suggests, the trading system operates at high speed. It executes buying and selling signals in just milliseconds. These use scalping or arbitrage based on easy price rise, and fall and included high trading volumes.
- News-Based
News-based algorithmic trading strategies are generally hooked to news wires. It generates trading signals automatically based on how the real data will turn in comparison to the previous data or market consensus.
Who Uses Algorithm Trading?
An experienced trader who has coding skills can use algorithmic Forex trading strategies to trade on their behalf. If you are an individual trader, you can code your own algo trading robot for doing more than simply buying and selling orders. Traders use algorithms for more complicated things, such as-
- Risk management
- Forecast market movements
- To create complex mathematical calculations
- Generate trading signals
The most efficient algorithmic traders are smart money and big institutions. Investment banks, hedge-banks, prop traders, pension funds, and broker-dealers use algorithms to make markets. These individuals are a significant part of algorithmic trading.
What is the Difference Between Algorithmic Trading and Automated Trading?
Automated trading automates the whole trading process. This means it will take over the entire process from screening opportunities in different financial instruments to deciding about buying or selling.
While algorithmic trading emphasizes on the trade’s execution process.
Bottom Line
Algorithmic trading Forex can improve efficiency and reduce trading currencies’ costs. It opens up a wide range of possibilities. For those struggling with discretionary trading, it is a great way to eliminate the issue.
However, it does come with some risks. The biggest of them is its prospective to increase systemic risk. Its tendency to intensify the market volatility ripples across the stoke investor and markets uncertainty.
So, you need to consider the risks and advantages before using it. Moreover, you need to ask yourself, can I come up with a functional trading algorithm that makes money consistently?
