Forex Algorithmic Trading: Understanding the Basics
The forex market was not as modern as today. For Example, the trades were executed over the phone, price information was not transparent, and market concentration was extremely low. However, technological changes have transformed the foreign exchange market incredibly. Trades can now be executed more quickly with computers and laptops. Moreover, there are no strict restrictions for traders to access the market. Additionally, real-time price streaming has made transparency possible.
The main objective of algorithmic trading is to improve forex trading functions. However, it is prone to certain risks; hence, you should know how forex algorithmic trading works in detail before applying it. Some of the most significant advantages of algorithmic trading are discussed here, along with the degree of risk attached.
Forex Market Basics
The forex market is considered the world’s biggest and most liquid financial market, where trading happens 24*7. In the forex market, currency pairs are traded in different volumes as per the quoted prices. Over time, investors have started getting their hands on forex trading because of its endless advantages. It lets them access the most advanced algorithmic trading tools that help in automated trading through various strategies available. Algorithmic trading lets traders trade speedily and accurately, but yes, there are certain risks.
Many players are a part of forex trading, such as banks, financial companies and institutional investors. The primary reason for the popularity of the forex market is that people have to exchange currencies to purchase goods and services in the foreign country. The forex market can significantly affect the exchange rates and therefore has an over influence on the employment, inflation, and capital of the country. This is why policymakers have a significant interest in the foreign exchange market.
Basics of Algorithmic Trading
Algorithms help to look for patterns by analyzing historical data to develop new models. In simple words, an algorithm is defined as a set of prescribed rules formulated to execute a particular task. In forex trading, computers are used to design algorithms based on pre-set rules such as time, price, and quantity which affect trades. A great benefit of automated forex trading is it eliminates emotional and psychological factors when making trading decisions and follows a logical approach. There are four kinds of algorithmic trading in the financial market:
- Statistical algorithmic strategy identifies excellent trading opportunities by analyzing historical time series data.
- Auto-hedging is an algorithm strategy that helps to minimize risk for traders.
- Algorithmic execution strategies are designed to achieve a particular objective, such as minimizing market influence or executing a trade quicker.
- Direct market access determines the optimum speed and cost at which the traders are able to access various trading platforms.
Another category of algorithmic trading is high-frequency trading, which is known for its high speed of trade execution. HFT has various benefits, such as it lets traders make trades in seconds of the price change. However, it possesses various risks, especially while trading in a highly volatile environment.
The tremendous popularity of algorithmic trading in the forex market is because it has helped automate particular trading processes and reduced the time required to conduct forex transactions. Algorithmic trading has brought greater efficiency, which has lowered costs in conducting various processes like trade order execution. Algorithms bring automation where trades are executed on the basis of certain predetermined criteria. Therefore, it is much more efficient as compared to manual trade order execution. Various banks also benefited from algorithms as they are designed to update currency pair prices automatically on different trading platforms. Algorithmic trading increases the speed of the banks when quoting market prices. It also minimized the time it takes for them to quote prices.
The benefits of algorithmic trading are not limited to these only. Algorithms are currently extensively used in speculative trading because of their data interpretation ability, allowing traders to take advantage of various opportunities that arise due to minor price deviations in currency pairs. The growth of the forex market has increased a lot due to the inclusion of algorithmic trading.
Risks in Algorithmic Forex Trading
Algorithmic trading has certain risks which limit its application. One such demerit is that it causes imbalanced trading power among the market participants. This is so because some participants might have the resources to buy this advanced technology for obtaining information and executing orders speedily, but others do not. This imbalance leads to fragmentation and causes liquidity shortages in the long run. Furthermore, algorithms are based on set rules and may not have the ability to respond quickly in case of market changes.
Algorithmic trading can bring efficiency and minimize transaction costs, but it comes with risk. Many investors ask for more effective regulation to control algorithmic-related problems that have come up in the past few years. But still, the trend of algorithmic trading has brought transparency to the forex market. Algorithmic trading has helped traders to exploit profitable opportunities. However, the main challenge of traders dealing in algorithmic forex trading is how can they implement it to maximize the advantages while minimizing risk simultaneously.