Importance Of Algo Trading In Futures And Options For Traders

Introduction

Small traders always wonder why only a select few gain big from the stock markets. Many don’t even know the tools the big fish have at their disposal. One such tool is Algo trading. I’m sure many of you must be familiar with the concept, but for many, it might be completely new.

Algo Trading or Algorithmic Trading uses a code that helps a trader read market fluctuations, identify mispricings and capitalise on them within milliseconds. These fluctuations are often not visible to the naked eye. Who benefits the most from such a program? The arbitragers who always capitalise on the smallest mispricings. However, it is gaining popularity in the masses lately.

In this blog, we cover, what is algo trading and why it is so important for futures and options trading in great detail. Keep reading to know more about the concept and how it works.

What is Algo Trading?

The concept of Algo trading is pretty simple. Market fluctuations are rapid and it takes time to identify an opportunity, place trades and execute them. This lag leads to the loss of opportunities. So, what is the solution? Algo Trading.

Let’s go a bit deeper. Have you noticed that the lag caused by humans can be easily avoided by using coded softwares? That’s exactly how algo trading works. Traders use computer programs with sophisticated algorithms. These programs identify and execute trades in the blink of an eye. 

The trades are automatically executed based on pre-defined criteria like timing, price and volumes. Algo trading is nothing short of a revolution in the stock markets. With access to advanced technology and high-speed internet, algo trading has become available even to retail traders.

Importance of Algo Trading in Futures and Options

Now you might wonder, what if you could use such a powerful tool for futures and options trading? F&Os are popular derivative contracts that require less capital investment to gain a bigger exposure in the market. As they are not stocks but derive their value from the underlying assets, they are highly complex and volatile.

This makes algo trading in futures and options for traders highly advantageous. Here’s why as an F&O trader, you should consider algo trading:

1. Speed and Efficiency

Speed is the essence of algo trading. Traders can identify and seize trading opportunities using algo trading within milliseconds. Manual traders can’t gain such an advantage over the programmed systems.

2. No Human Errors

Firstly, humans can’t meet the speed of algorithms. However, speaking hypothetically. Consider humans trying to do complex calculations in real time. Errors are bound to happen. Algo Trading provides this service accurately.

3. High Volume Trades

Another reason that shows the importance of algo trading when it comes to futures and options is the high volume of trades. With algo trading, you can execute multiple trades at the same time which is a boon in liquid markets. As F&Os operate at thin margins and require less capital, profits can be made only with high-volume trading.

4. Reduced Cost

Automatic order execution with algo trading is the key to minimise transaction costs. While placing F&O trades, even the thinnest of price differences can lead to losses. The trades are executed in real-time using algo trading. This removes the need to average your cost due to price fluctuations.

5. Better Risk Management

Algo trading acts on programs that include specific conditions. Unless these conditions are met, the trade isn’t executed. As a result,  the risk faced by traders in volatile markets is reduced. Algo trading allows traders to exercise better control over their investments.

6. Trade in Multiple Markets

Traders who trade in stock markets across the globe have a rough schedule. They have to work continuously around the clock to manage their investments in various markets. This leaves them no time for work-life balance. Algo trading empowers the traders by identifying and executing profitable trades without human intervention.

7. Diversification

The best way to spread your market risk is to diversify the portfolio. Algo Trading has inbuilt systems to ensure that your portfolio becomes balanced and you face minimum risk. Algorithms can also be used to prepare and execute complex hedging strategies to safeguard your investments.

8. Advanced Trading Strategies

You can use algo trading to execute advanced strategies that are not possible to even identify with the naked eye. Sophisticated strategies like arbitrage use heavy research and statistical analysis. Using technology for such calculations can provide a competitive edge to traders.

Popular Algo Trading Strategies

We just discussed the importance of algo trading. One of the key benefits is that you can apply advanced trading strategies. So, what are the popular strategies for algo trading in futures and options for traders, let’s discuss them in this section.

1. Market Making

Simply put, market-making strategies use algo trading to place multiple buy and sell orders simultaneously. These trades are executed within milliseconds and the trader earns the price difference, i.e. the bid-ask spread. As this strategy works only in markets with narrow spreads, speed and volume are the most essential assets.

2. Arbitrage

Just like market-making benefits from price differences in the same stock, arbitrage uses the price difference of a commodity or currency across different markets and benefits from it. Algo trading can help set up arbitrage, by studying price differences in markets constantly. 

The program automatically buys in the lower-priced market and sells in the higher-priced market maintaining liquidity and benefitting from the price difference.

3. Trend Following

Stock markets operate on trends. Usually, trend-following strategies use both short and long-term moving averages together to make investment decisions. Algo trading can instantly identify a shift in the trend and execute the orders accordingly. 

For example, there is a golden crossover point where 200-day and 50-day simple moving average trendlines cross each other. This strategy almost always holds good. Traders can use algo trading programs to identify it instantly.

4. Mean Reversion

Mean reversion strategies operate on the premise that the share prices will always move towards the average. So, algo trading can help identify significant differences between market price and the average. Trades are automatically placed if the price difference is significant. The importance of algo trading in such a strategy is that even the smallest price differences from mean values can be capitalised on.

To Sum it up……

After reading the blog, you must have understood the importance of algo trading. By integrating technology, trading can be revolutionised and it is exactly what algo trading is achieving. Unlike the beginning years when high-end technologies were available only to wealthy traders who could afford them, algo trading is reaching the masses. It has the potential to affect and change the lives of millions of traders across the globe.

To unlock the full potential of algo trading, open your DEMAT account with Angel One today!

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