Why do we use Algorithms or, as they are called, Algos?
“Trading floors were once the preserve of adrenalin-fuelled dealers aggressively executing the orders of brokers who relied on research, experience and gut instinct to decide where best to invest.” Richard Anderson BBC News
No longer do trading floors belong to adrenalin-fuelled dealers aggressively executing orders from brokers who relied on research, experience and gut instinct to invest. The game has changed. The Wall Street elite, in other words, the banks and hedge funds, are now using supercomputers armed with powerful algorithms programmed by PhD brainiacs to trade hundreds of stocks and currencies and in the process make boatloads of money.
Quant trading comes to Main Street
No longer are powerful algorithms the preserve of Wall Street Elite. Quant trading has come to main street and the average retail trader can now use that same technology to track patterns or trends in trading behavior and create algorithms to predict future market movements.
Although these quantitative trading programs are the basis of all quickfire trades (also known as high-frequency trading [HFT]), in which positions are held for a matter of seconds, these programs are now being used in more traditional trading where the holding period can be days, weeks or months.
No one has done the research, so we can’t be certain just how successful algorithmic trading is, but as Scott Patterson author of The Quants says: “They have been around long enough now to assume they are extremely profitable.”
Their proliferation would certainly suggest so. Two of the biggest HFT firms, Tradebot and Getco, alone account for about 15%-20% of all equity trading in the US. As they are private companies, it is hard to know precisely how far their influence extends but recent government-backed study in the UK estimated that between a third and a half of all share trading in Europe, and more than two-thirds in the US, was done by algorithmic trading, or Quant trading.
“The vast majority of firms use quantitative trading, It drives almost everything that goes on on Wall Street,” says Mr Patterson.
In the stock market, algo-trading (trading with an algorithm) is increasingly taking over the traditional way of trading as complex number-crunching algorithms work out what to buy and what to sell. Some estimates show up to 70% of Wall Street trading is now run by so-called black box or algo-trading.
Advantages of Quant Trading
There are many reasons why large hedge funds and mutual funds use quantitative trading systems to make trading decisions but the most important reasons for the average retail trader are:
- It eliminates unproductive emotions when trading. Emotion has always been, and will always be, the bane of a successful trading career. Even the best traders are plagued by emotions during a crucial trade because traders, before anything else, are still humans. Even if you have the best trading strategy, if emotions intervene at the most crucial point of a trade, all the best-laid plans can go awry. Quantitative trading systems eliminate such risks. It makes its trading decisions based on mathematically tested ideal conditions. Thus, no emotions are involved in the executions of trades.
- A quantitative system of trading can scan 1000s of symbols in minutes looking for patterns or setups, The sheer magnitude of this endeavor makes it impossible for a human without a computer.
- A quantitative system can be tested and validated; it does not merely rely on conventional trading wisdom. No bias or subjective analysis is ever introduced in the validity of the system. Therefore, trading confidence rests on quantifiable and tested values.
Trading with algorithms eliminate some of the worst habits a trader can develop, such as:
- Changing the rules for short-term satisfaction.
- Exiting early or refusing to take a trade to avoid pain.
- Falling into the rabbit hole called “solution mode” where you start looking for another indicator that would finally be “the one”, start digging into financials for more data on a company or think, “if I just did more research I would be a good trader.”
- Not believing you are as smart as 99% of those on Wall Street.
Quant trading differs from technical analysis because it:
- Removes the judgment when faced with ambiguous chart patterns.
- Replaces ambiguous indicators with mathematically precise indicators.
- Applies statistical validation to the resulting trading models.
- Makes trading decisions mechanical, objective, rule-based and judgment free.
Quant trading gives the average retail trader the ability to make boatloads of money, as long as you always follow this simple rule:
ALWAYS FOLLOW THE RULES