How do I start algorithmic trading?

Algorithmic trading, also known as algo trading, is a sophisticated and automated method of trading that has become more and more popular in recent years. It allows the execution of complicated strategies by using prior rules and algorithms.

If you would be interested to get into algorithmic trading, we will provide a useful introduction and guide to help you start off your exciting journey into the world of automated trading.

Building the right foundation

Prior to entering an algorithmic trading program, it is essential to have a good knowledge of financial markets. Familiarise yourself with the key concepts like market orders, limit orders, trading psychology, risk management, and asset classes. (i.e., stocks, futures, forex, cryptocurrencies). Read books, take online courses, and follow financial news to build and expand your knowledge.

Choose your instrument and platform

This will be one of the most important decisions of your whole algo trading life. For instance, your hobbies, knowledge, and tolerance for risk are important considerations. Every asset class has its own features and market dynamics. For example, stocks are greatly influenced by company-specific news whereas the forex market is influenced by geopolitical and economic events.

A reliable trading platform is your doorway to the world of algo trading. Spend enough time to have a good understanding of how these platforms function and select one that best suits you.

Programming language

Algorithmic trading is many times based on at least some level of programming. The choice of programming language is influenced by the platform you are using and the level of your coding skills. Python, for instance, is commonly used for algorithmic trading because of its simplicity and rich libraries. If you are not a programmer, please consider registering for online courses or hiring a programmer to help with your algorithms.

Choose or develop your algorithmic trading strategy

The trading strategy you adopt will become the backbone of your algorithmic trading. Define your strategy through developing clear requirements for when to enter and close out trades. Think of indicators like technical, fundamental, or sentiment analysis that your software will base its decision-making on. Lastly, mention your risk management parameters, for example, stop-loss and take-profit levels.

Algorithmic trading tactics: Technical Indicators

Indicators are crucial components of algorithmic trading tactics. Traders use such mathematical computations to analyse historical price and volume data.

Moving averages, RSI (Relative Strength Index), Stochastic Oscillator, Bollinger Bands, and MACD are some of the most frequently used indicators.

An example is the moving average crossover which can be a buy and sell signal and RSI which might indicate overbought or oversold conditions. These metrics provide quantitative insights into the performance of assets and direct algorithm trading decisions.

Fundamental Analysis

Fundamental analysis, in turn, concentrates on the economic, financial, and qualitative aspects of asset trading. Surprise reports can trigger buy or sell positions, while economic indicators can help algorithms to determine market expectations and consequently respond to the data releases in an appropriate manner.

Besides, algorithms may use natural language processing to infer news sentiment and change strategies of trading accordingly.

Analysing market sentiment

Market sentiment is one of the most important objectives of sentiment analysis. Algorithms can include the use of social media listening to discern the sentiments derived from keywords and discussions on structured platforms like Twitter and Reddit.

News sentiment analysis is another possible way for algorithms to study the sentiments of news articles and make decisions by considering sentiment data. Moreover, option flow analysis may shed light on market sentiment through monitoring uncommon option activity.

Risk Management

Risk management is the key element of algorithmic trading that will help you protect your capital. As such, the risk assessment analysis reports provided by platforms are comprehensive. Stop-loss orders function as safeguards by creating exit points for losing positions. Take-profit levels lock in profits at predefined levels. Another important aspect is position sizing, which decides the amount of capital allocated to each trade per risk tolerance.

Portfolio diversification spreads risk across various assets, thus reducing the effect that a single losing trade can have on one’s portfolio.

You can always adjust the risk management parameters so you can improve the chances of success of algorithmic trading.

Backtest your strategy

Before you take your algorithm live, test it using historical data. Backtesting entails testing how well your strategy has performed by using historical market data. Get historical price data for the assets you are going to trade. This data should span a significant period of time encompassing a range of different market conditions and levels of volatility.

Apply backtesting software or trading platforms with a backtesting feature. The most widely used trading platforms come with a feature of backtesting being already embedded. Make sure to precisely define your trading strategy, setting up the entry and exit conditions, risk management rules, and the use of technical indicators or filters.

Run a test of your trading algorithm by using historical data as if you were trading for real, but without the risk of using real capital. The algorithm will generate signals, execute trades, and be within the parameters you’ve set.

Evaluate the results of the backtest. Evaluate the number of trading wins and losses, the total return on investment (ROI), the maximum drawdown (the highest peak-to-trough decline), and the risk-adjusted returns.

Slippage occurs when the trade’s executed price diverges from the expected price. In backtesting, you have to emulate slippage as it happens in real markets, as it is another factor that could affect the performance of your strategy.

In actual trading, factors like spreads, commissions and fees impact your returns. Calculate these expenses in the backtest to find out how precisely your strategy will perform in live trading.

The process of backtesting helps demonstrate the strengths and shortcomings of the strategy. Take this feedback and use it to work on improving your strategy, make adjustments to the parameters you use, or even consider alternative approaches. Reoptimise the revised strategy to show improvements.

Perform backtests on many timeframes to verify that your strategy is strong and effective in different market conditions including the short-term and long-term ones.

Simulation for algorithmic trading

Once you’re satisfied with the backtest results, it is a common practice to perform paper trading or simulation trading to hone your skills further. This stage involves trading in a simulated environment at no risk to real money. Through paper trading, you’ll get the necessary practical experience and confidence in your algorithm.

Live trading

Once you are ready to transition from paper trading to live trading, begin small, and use less capital. This is a transitional phase when there is a shift from paper trading to actual trades in the market. Make sure you keep track of your algorithm’s functioning and also be prepared for possible changes.

Algorithmic trading: Monitor and adjust

The algorithmic trading program is a continuous process that requires constant tracking and improvement. A close monitoring of your algorithm performance will be necessary, allowing you to fine-tune it in case of changing market conditions. The adaptation and modification of the strategy is key to its long-term success.

Always remember that to protect your funds you should set specific stop-loss orders, follow position sizing rules, and limit the use of leverage to minimise losses. Algo trading can magnify profits, but it has risks that should be managed properly. By making trading decisions based on pre-set rules that are programmed into a computer, you will be able to eliminate emotion.

However, also be aware that a trading algorithm will react based on the rules that it is programmed on and could miss out on certain trades. While you could increase the number of indicators the algorithm should look for, this may not be bulletproof. Always be vigilant, assess the parameters and adjust accordingly.

Disclaimer:
This information is not considered investment advice or an investment recommendation, but instead a marketing communication. IronFX is not responsible for any data or information provided by third parties referenced or hyperlinked in this communication.