Algo Trading: How does Algorithmic Trading work?

An example of Algo-Trading?

While trading, this must have happened to you at some time or the other, where you have set the stop loss, the price hits that stop loss and suddenly reverses. Or it suddenly goes above the point where you were thinking of buying and you don’t even get a chance to enter.

On March 12, 2024, I saw the same thing in Nifty and Banknifty. The index first went up rapidly and then fell rapidly. And within the next few minutes, the index again came to the same price where it was in the beginning. Now this happened not only in Nifty and Bank Nifty but this fluctuation was also seen in some banking stocks.

But have you ever wondered why this happens? Now I read a lot of blogs to understand this and wanted to understand why this happens in the market, and what is the reason behind it. Then I came across it was Algo Trading.

Like you, I also had questions in my mind, what is this algo trading? And how does it work? But on most of the blogs, it has been explained in such difficult language and words that my brain stopped working. And thought why don’t I explain this topic to all of you in simple language?

Whatever information is available about Algo Trading, the data received says that at present, about 50 % of the trading that happens every day in the Indian Stock Market is done through a computer-automated system. That is, by unmanned automated machines.

That means the level at which you want to buy or sell, or where your stop loss is set. Computers are programmed to place thousands, millions of buy-sell orders at the same price.

What is (Algorithmic) Algo-Trading?

Algorithmic Trading means trading done by computer programs in the stock market. This is a completely automated process. In which a person sets a “set of codes” in a computer program, where he tells the computer in what situation and where he has to decide between buying and selling.

Every trader has his trading style. Some traders trade with the help of the 50DMA, and 200DMA moving average, some by looking at support and resistance, and some by looking at price action.

The same thing happens in Algo Trading. That is, here we give some information to the computer program in advance, where to buy and sell. For example, if the price crosses the 200DMA, then you have to sell, or if the price goes to a resistance, you have to sell, or if the price goes above the support, you have to buy. We also do this, but we do it manually. That is, you take entry and exit in the trade yourself. In Algo Trading, all this is done by a computer program.

How does algo trading work?

Now suppose you have a shop where you sell milk. And you see that every day there is a shortage of milk at a certain time. It is possible that whenever people come back home from work, they buy milk and there is a shortage of milk at the same time every day. What will you do in such a situation? To meet the demand for milk, you will again go to the market buy milk, and sell it from your shop.

Now that you know that every day there is a shortage of milk at some point in time, it is not easy to go to the market every day and buy milk. Then here you take the help of a computer system, where the data of your milk consumption keeps getting updated. So when there is a shortage of milk, your system automatically sends an order to the market. And the lack of milk is fulfilled automatically.
Here you just created a system. Which tracks your milk demand and consumption, and automatically sends orders accordingly. Here you did not do anything, whatever was done was done by your system.

This is exactly how Algo Trading works, it places orders for you in the market as per your instructions. In algo trading, you prepare some code in that system. Where you tell in which situation to buy or sell.

Like you follow a setup in which you like to sell if the share price goes below the 200-day moving average and buy when it goes above. So you create exactly such code in the system. After that, you don’t have to do anything. The system itself will track share prices and buy and sell them as per instructions.

Algo trading systems can be created using different technical signals, such as stock price, trading volume, support and resistance, moving average crossovers or any other technical signal you want to create. Then the program will track that data and automatically decide to sell or buy shares.

Algo trading systems create and execute orders faster than humans.
In algo-trading our emotions do not influence what you tell the system to do. The system will automatically complete its work in that situation.
But to do algo trading, you have to create a trading program, and you also need to know how to run it properly.
While it is emotionless, there is no guarantee of making the right decision every time.

Conclusion

In a nutshell, algo trading is like having a super-powered assistant for your stock trading. You set the rules (buy if the price goes up, sell if it goes down), and your assistant (the algo trading system) tirelessly monitors the market and executes trades according to your instructions. It’s fast, emotionless, and can potentially make you more money. However, keep in mind that building and using an algo trading system requires knowledge and there’s always a chance things might not go exactly according to plan.

FAQs

How does algo-trading work?

Algo trading uses a “Set of information” programmed by the programmer or trader. Hence, Trading works how it is coded, and information is set into the program, the system itself decides on buying, selling.

Is algo-trading a good idea?

Basically, the algo trading system requires knowledge and there’s always a chance things might not go exactly according to plan.