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Forex Algorithmic Trading Overview for Beginners.

Started by PocketOption, Apr 24, 2020, 07:04 am

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Forex Algorithmic Trading Overview for Beginners.
We all know that the FX market is the largest and most-traded market in the world. From its beginning to the present day, this market has significantly evolved. Around 30 years ago, the Forex market featured trading over the telephone. This market was accessible only for institutional investors. There was also the existence of opaque price information, meaning that there was hardly any transparency.
But, in the present scenario, technological advancements have drastically changed and improved the Foreign Exchange market. With the invention of the internet, trades can be quickly executed over the computer. This allowed the retail traders to enter this market as well. Today, transparency has also increased, and we get to see the real-time pricing effortlessly. Moreover, the distinction between the dealers and their highly sophisticated customers has been brought down.
Apart from these, another significant advancement was the introduction of Algorithmic Trading. This has fully automated the process of trading the Forex market. In this article, we shall be walking you through all the insights of Algorithmic Trading, right from understanding what Algorithmic Trading is about and the strategies involved in Algo-trading.
What is Algorithmic Trading?
As the name pretty much suggests, Algorithmic Trading is the process of executing trades automatically by pre-programmed instructions. The variables to this could be price, timing, and volume. Algorithmic trading is derived from the word 'Algorithm,' which is defined as the set of instructions to solve a problem in a finite amount of time.
The algorithms written for Algorithmic Trading is made up of complicated formulas, which combines mathematical problems and sentimental insights, to make trading decisions for buying and selling a security on the exchange. Algorithmic trading is primarily made possible by the high-frequency trading technology, through which traders can make tens of thousands of transactions per second. Apart from order execution, Algorithmic Trading can be used for trading as well as arbitrage and trend trading strategies. We will get to all this in the subsequent topics of the article.
Do-It-Yourself Algorithmic Trading.
Algorithmic trading has advanced a lot in recent years. Do-it-yourself is one such example of it. DIY is all about creating an algorithm based on the strategy. For example, in Quantopian (a hedge fund), the programmers compete to write the most profitable codes. And the best codes are paid a commission. All of this is made possible only from the high-speed internet and high-performance computers.
Furthermore, another emerging technology entered Wall Street. Machine learning and Artificial intelligence have enabled programmers to explore and improve in the domain of deep learning. Through this, Algorithmic Trading has been able to become more profitable.
Algorithmic Trading: The Process of Development.
Developing a strategy and implementing it as an algorithm could be a hard task if you are unaware of the process. Below is a step-by-step process for developing Algorithmic Trading systems.

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To have an idea to trade.
Whatever be the domain, it is necessary to have goals and objectives. In Algorithmic Trading too, it is vital to know where you would want to settle-up before you get started. Determine the market you wish to trade, and the revenue you expect to generate and the amount you can afford to lose.
To convert the idea into a trading strategy.
ust an idea is not enough to create an algorithm. The idea must be developed into a logical strategy. Any random strategy that's got no logic in point is most likely to fail. So, the key to profitable Algorithmic Trading is to design a solid strategy.
To program an algorithm based on the strategy.
Finally, it's time to program that strategy using fundamental computer languages like C++, MATLAB, Java, and Perl. As of now, the ideal programming language for Forex Algorithmic Trading is MetaQuotes Language 4 (MQL4).
Once the above steps are complete, it is time to backtest it. Backtesting is the process of checking the strategy using the historical price. This is used to test the viability of the strategy. If the algorithm turns to give good backtested results, it can be implemented in the live market as well. However, note that coding a strategy that offers profitable results is not a cakewalk sort of a job.
Benefits and Risks of Algorithmic Trading.
Reduces human effort.
The Forex market is a 24-hour market, and no trader can trade all day long. But a robot trader can do so. Be it day or night; it can trade anytime and for any amount of time. And traders can certainly take advantage of it.
Fades away emotions.
Every day trader goes through a roller-coaster of emotions. This can negatively hinder the trading strategy. But, Algorithmic Trading eliminates the emotions entirely while making a trade. As the process is automated, it will work exclusively based on the set of rules described in the strategy.
Wider opportunities.
A trader cannot work with several trading tools and currency pairs at once. They can choose just 1-2 securities and only a few technical tools. But, with Algorithmic Trading, the number of assets to trade, and the technological tools used on them can be countless. This would drastically increase the opportunities to trade.
Agreed that Algorithmic Trading has great pros, but there are downsides to it as well. Let's see some of them below.

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A typical algorithm cannot readopt on its own. The strategies work exceptionally well for a certain period of market situations. But, if something unexpected happens, the strategy fails. The Forex market works on both technical and fundamental analysis. But the strategies are built only on technical analysis. So, if any critical news occurs in the market, the strategy will fail to work. Getting in hand with a consistent and reliable strategy is not an easy job. Statistics say that only about 10-15% of the algorithms are worth using. Therefore, one may have to work hard to get hold of a good strategy. Moreover, Forex brokers tend to forbid trading with expert advisers. Finding a broker who allows traders to use their own strategies is troublesome.
Classification of Algorithmic Trading.
We know that Algorithmic Trading is programming an algorithm so that the computer can carry out the trades. These programs are not the same; they differ based on the objective it is used for. Concerning the financial markets, we have four types of Algorithmic Trading.
One of the most popular algorithms that spot profitable trading opportunities by considering the historical time series data.
Auto-hedging.
This strategy is designed to reduce a trader's risk on the trade.
Algorithmic execution strategy.
A strategy to execute a predefined objective, such as executing a trade quickly.
Direct market access.
This is to access multiple trading platforms with the best available speed and lower costs.
High-frequency trading.
This type of Algorithmic Trading is characterized by super-fast speed and a high rate of order execution. In this trading technique, traders get the ability to complete a trade in a time period of as low as milliseconds.
We aren't going in detail here because you don't have to know about them in dept. Just understand that these are the different classifications in Algorithmic Trading, and you will know when to use what in due course.

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Algorithmic Trading Strategies.
As already discussed, a profitable strategy can be designed with a strong foundation. Some strategies are already implemented by programmers and are most extensively used for Algo-trading.
Trend Following Strategy.
Moving averages, channel breakouts, and other related technical indicators are used for trend trading. Most Algorithmic Trading strategies are based on these indicators. These trading strategies are pretty simple to implement because they do not involve any price forecasts or predictions.
In these algorithms, trades are executed based on the occurrence of a trend without any predictive analysis. For example, the 50-day moving average and the 200-day moving average is a famous strategy in trend following.
Arbitrage Strategy.
Arbitrage about trading price imbalances across different markets and generating money out of it. In this strategy, you buy a dual-listed currency at a lower price in one market and simultaneously selling the same currency in another market offers risk-free profit or arbitrage.
The popular algorithmic arbitrage strategy is the pairs trading strategy. This is a strategy used to trade the differentials between two assets. In Forex, pairs trading is going long on one currency pair and simultaneously taking an equivalent quantity of the short position on the same currency pair.
Algorithmic Sentimental Strategy.
This algorithmic strategy is designed based on the news that generates signals (buy or sell) on how the data turns out to be. Moreover, the algorithms are written such that it can even give signals by analyzing the general retail market sentiments from the twitter data. This algorithmic strategy is unlike the trend following strategy as it tries to make predictions of the future price movement based on the current market sentiments.
Market Making Algorithmic Strategy.
Firstly, market makers are the brokerages that make the market for every instrument in the market. The instruments can be stocks, bonds, commodities, currency pairs, etc. Market makers are also referred to as liquidity providers. This algorithm is primarily used to provide the market with buy and sell quotes. It can also be used to match the buy and sell quotes. These algorithms are used to get in hold of the spreads.
Mean Reversion Algorithmic Strategy.
There are typically three states of the market, namely, trends, channels, and ranges. And it is believed that the market is in a range of about 80% of the time. And the strategy was developed in consideration of this fact. In a range, the price leans towards the average price. So, the algorithms were programmed such that it used the historical price to identify the average price of a security. The trades are executed in anticipation that the market will retrace back to the predetermined average levels.
Iceberging.
This strategy is mostly implemented by large financial institutions who secretively play in the Forex market when it comes to open positions. These large players, instead of executing one huge amount with one broker, they get it done in small pieces by different brokers. Their algorithms are such that the small positions are opened with different brokers in different points of time.
This is not brought into notice by the other market participants. In this manner, the big institutions can participate in the market under normal price movements without any sudden price fluctuations. This strategy is referred to as 'Iceberging' because the retail traders who keep an eye on trading volumes are able to see only the 'tip of the iceberg.' The combination of the Volume-weighted Average Price (VWAP) and Time-weighted Average Price (TWAP) is a synonym of this strategy.
Implementation Shortfal.
Implementation shortfall is the difference in the price that is intended by the buyer or seller and the final price that is executed after taking into account of commission, fee, and other charges.
The implementation shortfall strategy is created to cut down the execution cost of an order by trading off the real-time market. In doing so, the costs would be saved by benefitting from the delayed execution. In this strategy, the targeted participation rate will be made to increase when the prices shoot up and decrease when the price falls significantly.
Final Words.
The greatest advantage of the increased use of Algorithmic Trading is increased efficiency and reduced costs. As the participants in the market are growing, they are raising voice for better regulations and transparency in the Forex industry. And the adoption of Algorithmic Trading systems can prove to be helpful when it comes to transparency. Finally, the only aim in the domain of Algorithmic Trading will be to design more consistent profitable algorithms that will reduce risks along the way.