My Perspective on Algorithmic Trading (Part 2)

Today I want to continue by discussing some advantages to algorithmic trading.

The first advantage to algorithmic trading is automated backtesting. Backtesting assesses the viability of strategies by applying them to historical market data. While past performance is no guarantee of future results, strategies that perform poorly in the past are not typically recommended for live trading (see third paragraph). Backtesting requires trade guidelines to be unequivocal with regard to interpretation as the computer does not make guesses. Once programmed, historical backtesting takes seconds to minutes whereas manual backtesting [especially of discretionary, fuzzy strategies] can take weeks to months. Backtesting helps to fine-tune strategies or reject them outright by creating reasonable expectations for future returns.

A second advantage to algorithmic trading is emotional control. Individuals prone to overtrading are better served by a machine. Individuals scared to “pull the trigger” are better served by a machine. The human tendency to question trades can lead to delayed execution. Because algorithms execute automatically without emotional interference, algorithmic trading solidifies adherence to trade guidelines.

This is to say that managing emotion preserves trade discipline. Discipline may also be compromised by fear of losing or desire to squeeze out more profit from a trade. Algorithmic discipline reigns over even volatile markets.

“Plan the trade and trade the plan”—one of the most difficult tasks for traders to achieve—is embodied by algorithmic trading. Following trade rules precisely (neutralizing emotional influence) is the only way for backtested expectancy to be meaningful. Ruined confidence by consecutive losses jeopardizes this by causing trade delays. Since neither fear nor confidence apply to computers, strategies be executed flawlessly regardless of previous trade outcomes.

A third advantage to algorithmic trading is speed of order entry. What takes seconds to minutes for a person when pointing, clicking, and typing in multiple cells, radio buttons, or dropdowns is handled in milliseconds with a computer. Seconds (or worse) can make big differences in trade outcome especially when backtested expectancy assumes zero latency. Computers respond immediately to changing market conditions and are able to generate orders once trade criteria are met. Alerts need not be set or monitored. Exit orders are instantly generated.

With algorithmic trading, I will never have a trade retrace from a profit target or blow past a stop-loss level before I can an order to properly exit.

One other thing that will not happen with algorithmic trading is “fat finger” mistakes. This occurs when a trade is entered incorrectly (e.g. buy instead of sell, 10 contracts instead of 100, wrong symbol, etc.).

I will continue next time.