Automated trading explained

What is automated trading and how does it work?

Automated trading is a method of trading that uses an algorithm – based on a set of pre-defined parameters – to open and close positions on your behalf. In doing so, automated trading systems take the emotion out of trading, but also require constant monitoring and backtesting to ensure that they are working efficiently and correctly.

A trading system works by entering and exiting trades automatically once the set parameters are met. Say for instance, you were using an algorithm which was programmed to buy a certain stock at $100 and sell it at $110. It would do that, but only so long as the stock reached $110 exactly. Equally, you could add stops and limits to the trade so that, if the stock fell to $90, the software would close your trade for you, helping to prevent too severe a loss.

With IG, there are a number of automated trading platforms that you can use, including MetaTrader 4 (MT4), ProRealTime and L2 Dealer. These include ‘Expert Advisors’ and ‘automated trading strategies’ respectively, which enable you to fully automate the platforms with price alerts, and entry and exit levels for trades. You can also trade with IG using your own front-end solutions via API – and help with getting set up can be found here.

Pros and cons of automated trading

There are a number of advantages and disadvantages of using an automated trading system. Below, we outline what these are and make you aware of some key points that you should take into consideration before deploying an algorithm in your trading.

Pros of automated trading systems

• Eliminates emotion: by operating according to a collection of set rules, an automated trading system will execute your trades as instructed
• Backtest strategies: backtesting your algorithm on historical charts can generate information about the potential risk and rewards before you commit any capital. However, keep in mind that static data is not always representative of what will happen in a live trading situation
• Rapid execution: an automated trading strategy also executes your trades far quicker than a manual trading system would. Since they run according to algorithms, automated trading systems can place and close orders as soon as the fixed parameters are met, enabling you to minimise losses and realise profits.

Cons of automated trading systems

• Require constant monitoring: just because a system is automated does not mean that you can leave it all day to make trades and generate profits for you. An automated trading system requires constant monitoring to make sure that the underlying algorithms are working correctly
• Automated systems can struggle to translate from paper to practice: the creators of automated trading systems and algorithms sometimes incorrectly assume that the software should have a 100% success rate. But this is rarely, if ever, the case
• Off-the-shelf systems can be unreliable: automated trading systems often claim to be capable of doing the impossible. Don’t be fooled by these claims and make sure you test any new system thoroughly, as many third-party solutions fail to live up to their promises

As an example of what can happen when an algorithm goes wrong, it was supposedly a faulty algorithm which cost Knight Capital over $440 million in half an hour back in August 2011. The company attributed the loss to new software which rapidly bought and sold millions of shares in over one hundred different companies just after the markets opened.

Those trades pushed the value of the companies in question up, which caused Knight Capital to suffer a loss when they came to sell the now overvalued stock back into the market.

Automated trading vs manual trading

Many traders think that human judgment is key for success. Algorithms and automated trading systems have their benefits, but the human factor of manual trading allows for greater reactivity and flexibility if the markets are moving positively or negatively.

Algorithms cannot react to news events or stories the same way that humans can, and these events can seriously affect the financial markets. Traders look at news stories and events unfolding around the world as a basis for their trades. They might buy or sell depending on volatility in a geopolitically unstable region; or they might hedge their portfolio by trading a related asset when there are signs of a disadvantageous price move.

Automated trading systems will not do this, they will only react insofar as they are programmed to react – they will sell when told to sell and buy when told to buy. Moreover, automated trading systems can amplify the effects of flash crashes, as many algorithms automatically sell positions in response to downward trends.

Such an event occurred on 6 May 2010 when a flash crash caused American markets to lose almost $1 trillion in 36 minutes. Even with this astronomical loss, the markets still ended up closing just a few percentage points lower than they had opened that morning.

Automated trading strategies

While automated trading is used as an umbrella term to refer to algorithm-based trading, there are a number of different strategies which are commonly used by automated trading systems.

High-frequency trading strategy

A high-frequency trading strategy, as previously mentioned, enables traders and firms to carry out a large number of trades in a small amount of time. In this case, the automated trading system will open and close trades rapidly according to set parameters.

Third-party strategies

There are many third-party automated trading systems available on MT4 and L2 Dealer. Using an off-the-shelf solution enables you to get started with an automated trading system quickly. However, automated trading systems should always be tested thoroughly. As previously mentioned, many third-party systems will simply not come good on their promises.

Trend trading strategy

Trend following, or a trend trading strategy, uses automated trading algorithms to spot trends, and place and close trades in accordance with those particular movements. This could be over the course of minutes, hours, days or weeks.