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What Is Algo Trading and How Does It Work?

# What Is Algo Trading and How Does It Work?

Published May 31, 2024Updated Jul 23, 2024
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## Key Takeaways

• Algorithmic trading (algo trading) uses computer algorithms to automate the buying and selling of financial instruments based on predefined criteria.

• Strategies used in algo trading include Volume Weighted Average Price (VWAP), Time Weighted Average Price (TWAP), and Percentage of Volume (POV).

• While algo trading enhances efficiency and removes emotional biases from trading, it also faces challenges, such as technical complexity and potential system failures.

## Introduction

Emotions often stand in the way of rational decision-making in trading. Algo trading offers a solution by automating the trading process. In this article, we will explore what algo trading is, how it works, and its benefits and limitations.

Algo trading involves using computer algorithms to generate and execute buy and sell orders in financial markets. These algorithms analyze market data and execute trades based on specific rules and conditions set by the trader. The goal is to make trading more efficient and remove the emotional biases that can negatively affect trading outcomes.

## How Does Algo Trading Work?

There are numerous ways to do algo trading, and not all are efficient or successful. But to illustrate, we will go through some simple examples that can serve as starting points and give a basic idea of how it works in practice.

### Defining the strategy

The first step in algo trading is to define a trading strategy. This could be based on various factors, such as price movements or technical patterns. For example, a trading strategy might be as simple as buying when the price drops by 5% and selling when it rises by 5%.

### Programming the algorithm

The next step is to translate this strategy into a computer algorithm. This involves coding the rules and conditions into a program that can monitor the market and execute trades automatically.

Python is a popular programming language for this purpose due to its simplicity and the availability of powerful libraries. Here’s an illustrative example of how a simple trading algorithm might be coded in Python to trade bitcoin:

This code uses the yfinance library to download historical data for bitcoin (BTC-USD) and the pandas library to manipulate the data. The trading strategy is defined by creating buy and sell signals based on price movements. Specifically, the algorithm generates a buy signal when the price drops by 5% compared to the previous day's closing price and a sell signal when the price rises by 5% from the previous day's closing price. The execute_strategy function iterates through the data and prints buy or sell orders based on the signals.

### Backtesting

Before launching the algorithm, it is backtested using historical market data to see how it would have performed in the past. This helps refine the strategy and improve its effectiveness.

Here's an example of how to backtest the above strategy:

This code simulates buying and selling bitcoin based on the signals generated by the algorithm, tracking the balance over time. The backtest function initializes an account balance, iterates through the data to execute buy and sell orders, and prints the initial and final balance. This helps assess the performance of the strategy over the historical period.

### Execution

Once the algorithm is properly tested, it can be connected to a trading platform or exchange to execute trades. The algorithm continuously monitors the market, and when it identifies a trade opportunity that meets its criteria, it automatically places the trade.

Many platforms offer APIs (Application Programming Interfaces) that allow algorithms to interact with the market programmatically. Here’s an example of placing a market order using the Binance API:

This code uses the binance library to connect to the Binance API. It initializes the client with an API key and secret, then places a market buy order for a specified quantity of bitcoin (BTC) against USDT. The response from the API, which includes details of the order, is printed out.

### Monitoring

After the algorithm is live, it requires continuous monitoring to ensure it is performing as expected. Adjustments may be necessary based on changes in market conditions or performance metrics.

This can involve logging mechanisms that record the algorithm’s actions and performance metrics for review. Here’s an example of adding logging to the algorithm:

This code sets up a logging mechanism using Python’s logging library. It creates a log file named trading.log and records buy and sell actions along with the timestamp and price at which the actions occur. This helps keep a detailed record of all trades executed by the algorithm, making it easier to analyze performance and diagnose any problems that may arise.

Below are examples of some indicators that might be potentially useful in algorithmic trading strategies.

### Volume Weighted Average Price (VWAP)

VWAP is an indicator that can be used in a trading strategy that aims to execute an order as close to the volume-weighted average price as possible. The idea is to divide the total order into smaller chunks and execute them over a specified period, aiming to match the volume-weighted average price of the market.

### Time Weighted Average Price (TWAP)

The TWAP strategy is similar to the VWAP, but focuses on executing trades evenly over a specified period rather than weighting them by volume. This strategy aims to minimize the impact of large orders on the market price by spreading them out over time.

### Percentage of Volume (POV)

POV involves executing trades based on a predefined percentage of the market volume. For example, an algorithm might aim to execute trades that represent 10% of the total market volume during a specific time frame. This strategy adjusts the execution rate based on market activity to minimize market impact.

### Efficiency

Algo trading can execute orders at high speeds, often within milliseconds, allowing traders to capitalize even on small market movements.

Algorithms operate based on predefined rules and are not influenced by emotions, such as FOMO or greed. This can reduce the risk of impulsive decisions that can negatively impact trading outcomes.

### Technical complexity

Developing and maintaining trading algorithms requires technical expertise in both programming and financial markets. This can be a barrier for many traders.

### System failures

Algo trading systems are susceptible to technical issues, like software bugs, connectivity problems, and hardware failures. These can lead to significant financial losses if not managed properly.

## Closing Thoughts

Algo trading involves using computer programs to automatically execute trades based on predefined rules and criteria. While it offers numerous benefits, such as increased efficiency and emotion-free trading, it also comes with challenges, like technical complexity and the risk of system failures.