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Algorithmic Forex Trading
Written by: PaxForex analytics dept - Thursday, 02 June 2016 0 comments
A common dilemma for forex traders is whether to adopt a manual or algorithmic trading strategy that produces profitable outcomes over the long-term. But this question requires an individual to really understand their own capabilities when it comes to making decisions in high-pressure trades; and to recognize how technology can help overcome limiting psychological habits. All forex traders are susceptible to human tendencies that can affect judgment. But those who have the ability to monitor the patterns of their own mindset stand a far greater chance of developing a strategy that is consistently profitable.
Nearly thirty years ago, the foreign exchange market (Forex) was characterized by trades conducted via telephone, institutional investors, opaque price information, a clear distinction between inter-dealer trading and dealer-customer trading and low market concentration. Today, technological advancements have transformed the market. Trades are primarily made via computers, allowing retail traders to enter the market, real-time streaming prices have led to greater transparency and the distinction between dealers and their most sophisticated customers has largely disappeared.
Forex is the virtual place in which currency pairs are traded in varying volumes according to quoted prices whereby a base currency is given a price in terms of a quote currency. Operating 24 hours a day, five days a week, Forex is considered to be world's largest and most liquid financial market. The bulk of this trading is done for U.S. dollars, euros and Japanese yen and involves a rangeof players, including private banks, central banks, pension funds, institutional investors, large corporations, financial companies and individual retail traders.
An algorithm is a specific set of clearly defined instructions aimed to carry out a task or process. Algorithmic trading (automated trading, black-box trading, or simply algo-trading) is the process of using computers programmed to follow a defined set of instructions for placing a trade in order to generate profits at a speed and frequency that is impossible for a human trader. The defined sets of rules are based on timing, price, quantity or any mathematical model. Apart from profit opportunities for the trader, algo-trading makes markets more liquid and makes trading more systematic by ruling out emotional human impacts on trading activities.
An algorithm is essentially a set of specific rules designed to complete a clearly defined task. In financial market trading, computers carry out user-defined algorithms characterized by a set of rules consisting of parameters such as timing, price or quantity that structure the trades that will be made. There exist four basic types of algorithmic trading within financial markets: statistical, auto-hedging, algorithmic execution strategies and direct market access.
The forex market is remarkably unregulated despite handling $5 trillion-worth of transactions each day. As a result, regulators have urged the adoption of algorithmic trading, a system that uses mathematical models in an electronic platform to execute trades in the financial market. Due to the high volume of daily transactions, forex algorithmic trading creates greater transparency, efficiency and eliminates human bias.
A number of different strategies can be pursued by traders or firms in the forex market. For example, auto hedging refers to the use of algorithms to hedge portfolio risk or to clear positions efficiently. Besides auto-hedging, algorithmic strategies include statistical trading, algorithmic execution, direct market access and high frequency trading, all of which can be applied to forex transactions.
In investing, hedging is a simply way of protecting your assets from significant losses by reducing the amount you can lose if something unexpected occurs. In algorithmic trading, hedging can be automated in order to reduce a trader’s exposure to risk. These automatically generated hedging orders follow specified models in order to manage and monitor the risk level of a portfolio.
Within the finance industry, statistical analysis remains a significant tool in measuring price movements of a security over time. In the forex market, technical indicators are used to identify patterns that can help predict future price movements. The principle that history repeats itself is fundamental to technical analysis. Due to the increasing sophistication of computer programs, algorithms have been generated in accordance to technical indicators, including moving average convergence divergence (MACD) and relative strength index (RSI). Algorithmic programs suggest particular times at which currencies should be bought or sold.
Due to the nature of algorithmic trading and the forex markets, order execution is extremely fast, allowing traders to seize short-lived trading opportunities. Algorithmic trading requires an executable strategy that fund managers can use to buy or sell large amounts of assets. Trading systems follow a pre-specified set of rules and are programmed to execute an order under certain prices, risks and investment horizons. In the forex market, direct market access allows buy-side traders to execute forex orders directly to the market.
Based on complex algorithms, high frequency trading is the execution of a large number of transactions at very fast speeds. As the financial market continues to evolve, faster execution speeds allow traders to take advantage of profitable opportunities; in the forex market, a number of high frequency trading strategies are designed to recognize profitable arbitrage and liquidity situations. Provided orders are executed quickly, traders can leverage arbitrage to lock in risk-free profits.