Algorithmic trading in simple terms involves using computer programs to automate the trading (buying and selling) process of financial instruments (stocks, currency pairs, cryptocurrency, options). These computer programs are coded for trading according to the input that has been defined for them. The inputs could be based on the strategy aimed at taking advantage of different market behaviors such as the specific change in a price could trigger the algorithms to carry out specific transactions, or other factors such as volume, time or algorithms sophisticated traders based on trading indicators.
Who uses algorithmic trading?
By far, the most common fans of executing algorithmic trading are large financial institutions as well as investment banks alongside hedge funds, pension funds, brokers, market makers.
Some well-known algorithmic strategies:
In the broad sense, the most commonly used algorithmic strategies are Momentum strategies, because the names indicate the start-up execution of the algorithm according to a peak or a given moment. The algorithm basically detects the moment (for example, the peak) and executed by and sells the order to find out how it was scheduled.
Another popular strategy is the medium reversion algorithmic strategy. This algorithm assumes that prices generally return to their average.
A more sophisticated type of algorithmic trading is market making algorithms; these algorithms are called liquidity providers. Market Making strategies aim to provide buy and sell orders in order to fill the order book and make a certain instrument in a more liquid market. Market making strategies are designed to capture the gap between the buying and selling prices and ultimately narrow the gap.
Another advanced and complex algorithmic strategy is that of arbitrage algorithms. These algorithms are designed to detect pricing errors and distribute inefficiencies among different markets. Basically, arbitrage algorithms find the different price between two different markets and buy or sell orders to take advantage of the price difference.