Is Algorithmic Trading the Solution?

If the market has given you a headache over the last year, then rest assured…you are not alone.

Just as the market looked to have found a base, the bottom fell out of it. And just as the band was readying to play the old funeral march, it sputtered to life once again.

Up and down. Round and round. Like a bowling ball knocking skittles out of its path.

It’s this kind of market that can hurt everyone. Just as a trend seems to be in place, it evaporates into thin air.

That can mean getting stopped out of a position no sooner than you get in. Burning up chunks of capital as the market churns you over and over.

Sure enough, it can be very frustrating. It is something that does not change until either the bulls or bears win, and the market finally finds its direction.

A choppy market doesn’t mean, however, that you have to sit on the sidelines. What it does mean, though, is that you might have to find different strategies instead.

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The advantage of algorithmic trading

The words ‘algorithmic’, or ‘computerised’ trading, is enough to give most investors the heebie-jeebies. It all seems a bit mysterious, beyond the scope of you and me.

And in some ways, that is right. Some of the more complex trading strategies involve a level of maths and programming that few could ever understand.

An algorithm, though, is simply an instruction to do something.

The only difference between you or I doing it, and someone using a computer program to do it, is that we typically place each order manually ourselves.

Consider a stop-loss order. Traders will usually decide on a stop level before they enter a trade.

The stop-loss might be a fixed percentage below the entry price. Or, it could be a trailing stop that tracks behind the trend. Whatever strategy you use, the stop-loss trigger is an instruction to exit the trade.

An algorithm is simply an instruction to execute this trade — in this case, a stop-loss — on your behalf. Where computer trading differs is that it can do hundreds of trades at once.

You’re probably doing it already

Perhaps the most common computer trading strategies are momentum-based. That is, entering a position in anticipation of a breakout move.

It is the kind of strategy that investors blame when the market takes a big fall.

Momentum trading, though, is just one of countless strategies. Another strategy that is also popular, but you never hear about, is ‘mean reversion’.

Perhaps that’s because it just sounds too complicated. Or maybe even a bit boring. Writing about it probably only serves to remind readers of some old dreary maths class they had to take in high school.

But you and I use it every day, even if we don’t know we are doing it.

When you fill up your car, you know instinctively if you are paying too much. From driving around, your brain absorbs all the advertised prices. It soon works out what the average should be.

If a service station’s price is below that average, we stop and fill up. Similarly, if the price is excessive, we might give it a miss. Or, only partly fill up until the prices come back down again.

Well this is exactly how it works in the markets. All mean reversion means is that you are trading prices below or above the average, in anticipation of them coming back to that average.

You aim to buy when a price is below average. And, look to sell (or short-sell) if it is above average. What you are aiming to capture is the swings between the extremes.

But how do you know what the average price is?

There are a number of ways you can work it out. Perhaps the simplest way is to use a moving average. That means averaging out the closing price over the last three weeks, or two months, for example, or whatever period you choose.

As I say, you look to buy below average and exit once the price hits the mean (or average). And sell when it’s above the average.

It’s a strategy that works best in a sideways market. But you can still use it in a market grinding slowly in either direction. Just not when it’s moving too fast.

Like any strategy — momentum, trend following, or whatever you use — mean reversion does not always work. However, it is a useful strategy to add to your toolbox. Particularly when the markets are bouncing sideways.

Regards,

Matt Hibbard,
Editor, Options Trader

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Matt Hibbard is Money Morning’s income specialist. With nearly three decades in the markets, Matt has traded just about every asset class there is. The one thing that has stuck with him over this time is a very simple premise. That is, it’s the cash a company generates that ultimately determines its value. Sure, some stocks might fly away to multi-digit gains. But unless these companies can convert the ‘story’ into real money, the market will eventually find them out. And when that happens, the share price quickly falls back to Earth. That’s why, over at Total Income, Matt is on the hunt for the next generation of dividend-payers. Stocks that should be able to pay their shareholders reliable and rising dividends into the future. Matt is also the editor of Options Trader, where he shows subscribers how to use basic options strategies to generate income. This is income they can generate on top of regular dividend payments. Matt doesn’t play the prediction game, where the aim is to be proven ‘right’. Instead, his goal is to generate as much income as he can for his subscribers, irrespective of whether the market is going up or down.


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